Volatility is plunging as stock prices rise

Volatility index, a measure of the standard deviation, or how much the stock market is expected to change in the coming year is down below 16%. This has led to an increase in stock prices.

The VIX uses options pricing to measure the market’s expectations for future swings in the S&P 500. It tends to fall when stocks rise. The VIX came close to 50 last summer when stocks were swooning and many were fearing a double-dip recession. It was also over 30 as recently as early December. But the VIX has had a relatively smooth ride lower throughout much of 2012.

If volatility comes back (a measure of risk), expect stock prices to fall to compensate new stock purchasers for bearing the additional risk.

French election results cause VIX to crash

In chapter 9, we learn that, in the long run, risky assets must return enough to compensate shareholders for bearing risk.  So when the risk suddenly declines, current stock prices increase to reduce expected return.

Colleague Bob Whaley's VIX index (previous blog posts on VIX), which measures risk in terms of the implied volatility, declined suddenly in both the US and EU as it became likely that the pro-EU candidate would win the French election.

Reducing leverage hurts options buyers

Financial options on funds are bets that, e.g., a fund's price will increase up to a specified strike price.  Leverage tends to make a fund more risky, and more likely that the fund price will hit the strike price at which the option pays off.  

So far so good.  But for every person who buys an option (long) hoping that the price will increase to the strike price, there is a seller on the other side (short), who hopes that it doesn't.  

Colleague Bob Whaley has pointed out that changes in leverage of the fund can reduce its volatility which would make it less likely to pay off (link).  Using data from 2018, Whaley gives an example:

...ProShares had reduced its leverage ratios in Ultra VIX Short-Term Futures fund (UVXY) and its Short VIX Short-Term Futures ETF (SVXY). The combined market value of options on the two names fell more than $116 million, ... 

These types of corporate events, not accounted for properly, result in “windfall transfers of wealth from outstanding long to outstanding short option holders,” Whaley concluded. 

BOTTOM LINE:  Beware of buying options on funds that can change their own volatility.  (I wonder if anyone sold options on the stock who had had control of the fund's leverage.  If so, it is a textbook example of Moral Hazard!)

Are investors ignoring risk?

Volatility (measured by VIX) is at an all time low, the stock market at an all time high.  VIX measures the volatility implicit in the futures contracts that investor's buy.  It can be thought of as the price of insurance against a stock market plunge.  Right now, investors are not willing to pay much for insurance because they think the probability of a plunge is small.

What could go wrong?

To see the answer to this, look at early 2007, when volatility dropped to about the same level.

Where has all the volatility gone?

The VIX index, (invented by Vanderbilt's Bob Whaley) measures the implied volatility of the market, from options prices.  It is at an a very low level.  So either volatility has disappeared, or investors are ignoring volatility in search of higher return:

From the WSJ:

“I still smell smoke,” he said. “The level of complacency implied by the low VIX does not correspond with all that we’re hearing about how disappointing earnings season is going to be,” he added.

From the FT:

“It’s still a high volatility-of-volatility world, and volatility can turn around quickly,” said Rocky Fishman, a strategist at Deutsche Bank.

From Market Watch :

According to contrarian investing 101, low volatility means high complacency, and high complacency is usually seen near major market tops.

Uncertainty causes recession

In a previous post, we showed a negative correlation between the stock market and colleague Bob Whaley's "Volatility Index," VIX.

Recent research shows that volatility spikes are a good predictor of future recessions because:

• When people are uncertain about the future, they wait and do nothing.
• Firms do not to hire new employees, or invest in new equipment if they are uncertain about future demand.
• Consumers do not buy a new car, a new TV, or refurnish their house if they are uncertain about their next paycheck.

The economy grinds to a halt while everyone waits.

How the US Presidential race is roiling markets

As odds of a Clinton victory fall,

or the increased likelihood that Clinton will not be able to govern, even if she does win, has caused the VIX, which measures volatility/uncertainty about the US stock returns (invented by colleague Bob Whaley) to rise.  The expected yearly movement (standard deviation) in the S&P is up to 17%.  

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Hat tip:  FT

Where has the risk gone? (VIX)