Volatility and VIX Hottest Words in Investment News

The selling we saw last week and on Monday of this week caused the words “volatility” and “VIX” to become the hottest words in investment news. On Yahoo Finance’s home page, without even typing in any search words, there were more than 25 articles with “volatility” or “VIX” in the title of the article. For the time being, they have supplanted “cryptocurrency” and “bitcoin” as the hottest buzz words.

In order to discuss volatility and what it means to you as an investor, first I think we have to define it. Originally I thought I would give my own definition, but I found a simplified definition on Investopedia.com that does a good job of defining volatility.

“… Volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.”

Greater volatility means a wider range of prices and lower volatility means a smaller range of prices. That is simple enough. And by that definition, we have seen a tremendous increase in volatility toward the stock market in recent days. In Tuesday’s action alone we saw the S&P 500 trade in a 108-point range from low to high. Monday the low and high were 125 points apart. For comparison purposes, the index didn’t move more than 100 points from October 5 through November 30, or from November 22 through January 3.

Seeing 100-point intraday changes in the S&P after such long periods without much movement is certainly alarming to investors, especially when the market had just had its longest streak without a five-percent correction ever.

One of the reasons for the headlines regarding volatility, besides actually seeing it increase, was the huge reaction from the CBOE Volatility Index or VIX. The VIX was created in 1993 and used options on the S&P 100 to measure how volatile the market appeared to investors based on the implied volatility priced in to both call and put options. In 2004, the VIX started using options on the S&P 500 to reflect the volatility of a broader index.

The chart shows how the VIX has traded over the last 20 years and it shows the crazy spike over the last few days. It also shows how low the index was in 2017 where it spent more time below 10 than it ever had before. The problem is that it jumped too much and that has people questioning its validity and whether there are issues with the calculations. We see that during the bear market from 2007 to 2009, the index jumped from down below 15 to a high up near 90, but it did that over the course of a couple of years and peaked in October ’08 during the height of the financial crisis.

From a percentage standpoint, the VIX jumped almost 600 percent from the beginning of 2007 through the peak in October ’08 and it did so as the S&P fell 38 percent. In the current situation, the VIX jumped over 300 percent in the past month while the S&P was only down 3.4 percent. How is that possible?

From my own perspective, there are several reasons for the distortion between the jump in the VIX and the drop in the S&P. First, the rise in the number of ETFs offered toward the VIX has made it too easy for investors to bet on rising or falling volatility, especially the leveraged ETFs. One of the most popular trades in the past year has been betting on low volatility and one of the most popular means of making the trade was buying the VelocityShares Daily Inverse VIX Short Term ETN (Nasdaq: XIV). The term ETN means Exchange Traded Note as opposed to ETFs which are Exchange Traded Funds.

We see that the volume on the XIV has been steady with a few spikes here and there, but the average daily trading volume is around seven million shares a day. We see that the volume jumped to almost 50 million on Monday and then the XIV lost over 92 percent of its value yesterday. This dramatic decline was so great that Credit Suisse, which owns a 32 percent stake in the ETN, announced plans to liquidate the XIV on February 21.

The XIV was designed to allow investors to bet against volatility and here it is contributing to volatility. Anyone else see the irony there? Credit Suisse wasn’t the only financial institution to liquidate a VIX product either. Nomura Holdings, Japan’s largest brokerage firm, has also announced plans to liquidate a similar product that it offered.

While the XIV has certainly contributed to the disproportionate move in the VIX compared to the decline in the S&P, it isn’t the only reason. I also think the huge transition to passive investment management by a great deal of investors is contributing. With passive management using index funds rather than individual stocks or even sectors, it makes it easier for investors or their investment managers to hedge the portfolios by using S&P options, a leveraged inverse ETF, or a VIX exchange-traded product.

In an article from CNBC, Larry McDonald, founder of the Bear Traps Report, shared the following stats. “Positioning in all sorts of VIX ETFs has increased 5-fold in recent years,” McDonald said in an email. “Even a spike in volatility similar to August 2015, would force VIX ETFs to buy an incredulous $37 billion exposure in short-term VIX futures. Such a spike can even get more exacerbated in case liquidity dries up as the market realizes certain structures need to rush in and cover their shorts at whatever the cost.”

This type of information seems to suggest that we aren’t going to see a significant decline in volatility anytime soon, at least not in the VIX. That doesn’t necessarily mean that the volatility in stocks is going to remain elevated as it seems the VIX is trading independently from the actual index from which it derives its value.

That is one of the risks in trading any derivative. Sometimes the pricing of the derivatives themselves are not in synch with the underlying security. That seems to be the case here and as I said earlier, how ironic that products that were meant to measure volatility and bet against rising volatility are contributing to a jump in volatility.

Unless you were invested in the XIV or another VIX ETF, I wouldn’t worry too much about the spike. While the turbulence we have seen in recent days is concerning, these factors should not weigh in to your decision making about your own portfolio. The market was too high and investors were too optimistic. We needed this stretch of volatile trading in order to let off some steam and drive some investors out.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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