Why Buy Volatility Products Now?

The CBOE Volatility Index (VIX) may be "overdue" for a volatility pop

May 11, 2015 at 9:13 AM
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"Despite gathering clouds, don't bet on a volatility storm." At least, that’s what this pundit says on what some are calling the greatest Yahoo! Finance interview ever.

"Given lackluster corporate earnings and anemic GDP, you’d think investors would be worried. In turn, you’d think the CBOE Volatility Index, or VIX, would be spiking.

"Yet that’s not the case; in fact VIX is down sharply over the past 3 months. Although that may seem counterintuitive, Schaeffer’s Investment Research contributor Adam Warner says the price action makes all the sense in the world. People call the VIX Wall Street’s fear index, but 'it’s not an emotional gauge,' he noted. 'It’s a measure of volatility expected in the market within the next 30 days.'

"And looking forward, Warner as well as Mike Santoli of Yahoo Finance, both said options traders see no reason to expect a particularly volatile market in coming weeks. 'Summer is coming and in the summer the market tends to go to sleep; it’s a seasonally slow time,' Santoli said."

Well, maybe. But let’s say this guy -- who I’ll call "me" -- is wrong. Why should I want to buy options or volatility products now? 

Well, this range can’t last forever. The SPDR S&P 500 ETF Trust (SPY) has hovered in a range of 204 to 212.50 since early February. That's about 4% low-to-high over three months, which is quite tight. It's conditioned traders to sell index strangles and hedge unaggressively. It's impossible to say when that range will break, but it's not impossible to say that there will be several trapped options charts at the break. The longer it holds, the more the shorts get confident, and then the more pain when it goes against them.

And there are signs something may happen. Realized volatility within the range is increasing. Ten-day realized volatility in SPY is now 13.5, which means you’re actually buying the CBOE Volatility Index (VIX) at a small discount. That’s unusual at a time when we’re not really moving anywhere.

And finally, we’re a bit overdue for a vol pop. VIX last closed 20% above its 10-day simple moving average in early January.  So we’re now four-plus months removed from our last major VIX-plosion. That’s on the longer end of normal. I should note we went about six months last year this time with an overbought signal -- and then saw a cluster of VIX mini-panics, so maybe history is repeating and we’re still a couple months away.

Throw it all together and I mostly agree with Video Me. I’d rather miss the next vol breakout than pre-anticipate it.
 

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