Why It's So Tricky to Time Volatility Spikes

The CBOE Volatility Index (VIX) is more predictable than some analysts suggest

Dec 23, 2014 at 8:37 AM
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I know you may find this shocking, but some strategists out there expect volatility to pick up in 2015. This, via Bloomberg:

"'We do think the dominant feature of U.S. volatility will be these excessive, localized shocks that will continue to repeat,' Benjamin Bowler, Bank of America's co-head of global equity derivatives research, said by phone.

"[...]'Our view is that volatility across assets in 2015 will look more like the fourth quarter than the first half of 2014,' [Marko] Kolanovic, global head of quantitative and derivatives strategies at JPMorgan, wrote in a Dec. 15 note. 'October's shock is an example of the market volatility we are likely to see in 2015 as the Fed increases rates and the market adjusts to lower levels of liquidity.'"

I do agree that we will continue to see sporadic shocks in 2015. But, I believe we will see them in 2016 too, as well as 2017, and 2018, and -- well, I think it's safe to say that a year won't go by without seeing vol shocks. That's because they happen pretty much every year, two to five times, generally speaking.

I say that because in the 25 years (gasp) I've either followed, traded, and/or written about volatility, there's a surge about every three to four months, on average. Sometimes it's more frequent, sometimes less. Technology has sped up trading exponentially. Humans have given way to algos, volume has exploded, etc. The Fed has tightened and loosened, foreign and domestic crises have come and gone, and so on. But one constant remains: volatility stays dormant for the majority of the time, and then periodically explodes. Markets disregard "important" news for months on end, and then all of a sudden obsess over a few stories. And then, before you know it, those stories are disregarded and discounted.

Timing those explosions is difficult. The entire investing world knows that the Fed plans to raise interest rates in 2015. Will the anticipation cause volatility to spike? How about the actual announcement? It's not a sure thing -- in fact, you can make a very strong case that since everyone knows it's coming, it's not going to cause much of a vol spike. More likely, the next spike will come from an event not on our radar now. And even more likely, that vol spike will be the result of us simply being due for one, and will get retroactively correlated with whatever news was around that week.

So, why not just buy puts or CBOE Volatility Index (VIX) futures now, knowing there's a vol spike coming at some point, very likely by March or April? There's a cost in owning volatility. The value of standard options decay over time. VIX futures almost always trade at premiums that decline as they approach expiration. The iPath S&P 500 VIX Short-Term Futures ETN (VXX) loses money into contango in the futures curve, in addition to the premium erosion. Implied volatility itself prices above realized volatility. Ergo, you really need to time your bets on vol spikes well in order to profit.

When I traded as a market maker, the order flow always got us long volatility. The world as a whole always wanted to buy-write, so thus we ended up owning every call on the board, and had to short stock on ratios as a hedge. By and large, the position didn't work. But every so often, vol would spike and we'd have to capitalize as much as humanly possible. The trick was to tread water as best you could in the vast majority of the time that volatility was flat or sinking.

The business has changed wildly, but the same basic principle still holds. If you can figure out how to benefit from rising volatility while not losing too much in the endless periods of time when volatility flatlines, you'll do quite well. It's much easier said than done.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.



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