On Complacency
Why volatility has likely made a low here
Modern financial markets are highly developed. Over the past decades they have created ever more refined concepts for investors to hedge against a myriad of risks, and for observers to use their pricing for clues on the economy and markets
One of these concepts is volatility, as measured by the VIX index (“vol”) and its first derivative, the VVIX index (“vol of vol”). These are created by the pricing of options. Why?
If option sellers expected volatility to be high, then they price options more expensively. High volatility means prices swings are larger, which in turn means the strike price of an option is more likely hit, leading to a loss for the option seller. So they want to be compensated for that risk
Conversely, if option sellers do not worry about volatility, they will sell their options more cheaply
A low volatility reading tells us that market participants have no fear of wider market swings ahead. Now, regular readers will be familiar with my constant search for market extremes and my intention to fade them. I believe the market’s volatility readings have reached an extreme low, an the odds are it rises from here
First, let’s look at the VIX Index. It has just touched a 6-year low (!):
More so, the volatility of the VIX itself, measured by the VVIX index has also reached a multi-year low:
This tells us investors not only expected volatility to be low now, but also to stay that way. If the volatility of volatility (“vol of vol”) is exceptionally depressed, very few expect big moves in the VIX any time soon
In other words, investors currently expect exceptionally calm markets, and expect them to stay that way, too
Now, if we look at the VVIX chart above, we note that these spikes to the downside usually reverse pretty quickly. Keeping reflexivity in mind, that makes sense. Why?
If volatility and its first derivative, the VVIX are exceptionally low, everyone has their guard down. In this environment, policy makers may be too complacent to take forceful action, geopolitical adversaries may see an opening, or pricing may simply next move in a way that is uncomfortable for many
I think it is likely that volatility has made a low here. What will drive it up? I don’t know, but here are some dynamics that could be made responsible soon:
China could impose aggressive sanctions on Taiwan if the incumbent party wins again this weekend. It has indicated to do so, yet this seems ignored by markets right now
The Middle East crisis could resurface, e.g. via an escalation in Yemen
The US economy could deteriorate more than expected, meaning the Fed is behind the curve with rate cuts
It does not always need a negative scenario to drive up volatility. Also consider the following an option:
Some think that the Fed (and the Treasury) are already way too lenient right now. A “crash-up” in risk assets might follow, as investors rush to the safety of real assets amidst excessive and inflationary deficit spend. Emerging markets such as Brazil provide a template for it
I will write about this in one of the coming posts, and why I see it as the less likely outcome
The economy and markets are a reflection of human behavior. If volatility is low, something new may suddenly cause substantial stress just by virtue of being new. Conversely, when volatility is high, something known may start to be disregarded
Just think of the Israel/Hamas conflict. The first headlines saw market volatility rush upwards in October. It has been going on since, and has arguably escalated with the involvement of Yemen. Yet, as volatility had declined from elevated levels, no one in markets was in the mood to hear about it anymore
Conclusion:
Markets very often take pricing to extremes, and in my view volatility (VIX) and “vol of vol” (VVIX) currently represent such an extreme. I think it has put in a low for some time
There could be plenty of reasons to drive up volatility going forward, from geopolitical tensions around Taiwan or the Middle East, to monetary policy that may be slow to adjust, or even a “crash up” in risk assets (latter not likely in my view)
What does this mean for markets?
The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence
In light of today’s post, I bought VIX call spreads with March maturity. As both volatility and “vol of vol” are historically cheap right now, these offer very good risk/reward to an increase in market stress, wherever it may come from, and whether it would be positive or negative
In addition, I used the sell-off in oil stocks this week to enter a position again. Yes, long oil or oil majors is at odds with my my view of an economic slowdown as I spelled it out in recent posts. But:
The positioning is very one sided in the physical commodity, and no one owns the equity sector. I see a likelihood of higher geopolitical tension and obviously my economic view may be wrong, the chart looks good (see below) so I have given it a shot with a tight stop
Besides that, my positions remain the same:
Small long some producers of commodities with very tight supply/demand balances, hedged with a Russell 2000 short
Equity downside exposure via US index put spreads with Spring expiry
Cash (i.e. T-bills)
Further:
I continue to expect the US Dollar to strengthen vs its G7 counterparts
I am still looking for exposure into humanoid robotics, where the car company with the mercurial CEO probably offers the best prospects. However, it is currently dragged down by worries about its automotive business, so I’ll try to wait for that to run its course
For bonds, the consensus seems that too many cuts are priced in for ‘24. The bond market loves to throw consensus off and stop everyone out, so I could see the 2yr yield come down further. I find bonds hard to read right now, so I have no position (they should have sold off on the “warm” CPI inflation print and likely good retail sales today but didn’t)
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You name 3 reasons why volatility could drive up. 2 of them are related to geopolitics, and even though you might be right on the outcomes, i find it very hard to trade based on geopolitics. If anything (in my personal experience), increasing uncertainty is usually short lived, which confirms the mean reverting nature of volatility. While you're certainly right on the current low levels of both VIX and VVIX, I find it extremely difficult to time to catch spikes, so i mostly watch the action from the sidelines. I usually use the ratio of VVIX / VIX to time vol spikes, this one is on its way back down. Best luck with the call spread and thank you for you valuable content.
I agree there's an unwarranted level of complacency in the market. That said, I'd be careful with historical comparisons of the VIX. The demand for 30 day options has been decreased by the boom of 0 DTE options. Traders now have the option to buy much shorter term hedges and are doing so, thus the recent introduction of the 1 day VIX by the CBOE.
In the long run I think this is good for market transparency as 30 day measures of volatility aren't skewed by 1-day events in the window (Fed meetings, earnings, NFP reports, etc).