If the VIX sustains a rise above 20, it may be wise to hedge a portfolio in anticipation of even higher volatility and resulting stock declines.
(Editor's Note: Steven Sears is on vacation. Today's guest columnist is Jim Strugger, the derivatives strategist with MKM Partners, a Stamford, Conn.-based institutional investment research firm.)
Following five years of volatile stock markets, many investors are pining for the relative calm of earlier periods, like 2003-2007, when the Chicago Board Options Exchange's Volatility Index, the VIX, was capped around 20 and the Standard & Poor's 500 index sustained an upward trajectory that totaled more than 90%.
It's easy to be wistful. Our current reality is very different, and given the likelihood that a high-volatility regime will remain intact for several more years, we remind investors of a simple rule of thumb that can help manage risk in turbulent environments: When VIX sustains a rise above 20, take caution. It was trading at slightly under 18 in midday trading Thursday.
The history of equity implied volatility is rooted in listed options trading over the last 40 years, with market makers and a relatively small number of money managers focused on exploiting short-term divergences.
But since the fall of 2008, when VIX spiked above 80 to define the most traumatic point of the financial crisis, more fundamentally oriented institutional and retail investors have elevated the importance of the VIX and other options-market metrics, such as skew and implied correlation, in their analyses of equity-market risk.
The advent of exchange-traded volatility-linked products beyond VIX options and futures has provided a straightforward means for expressing directional views of volatility and hedging against the types of shocks that have occurred repeatedly over the last several years.
There is compelling evidence of this multiyear shift: Daily U.S. listed options trading volume is up 60% since early 2008; open interest of VIX options recently reached an all-time high of around 6.5 million contracts; and the iPath S&P 500 VIX Short Term Futures ETN (ticker: VXX), the most actively traded volatility-linked product, ranks in the top five and top 10 among exchange-traded products for daily cash and options volume, respectively.
For all of this newfound interest in volatility, there is scant analytical work that effectively harnesses its unique underlying properties. Empirically, we know that the VIX time series exhibits mean-reverting and path-dependent characteristics. This suggests that the recent history of implied volatility will play an important role in determining its route forward as it tends toward the long-term average. Think of a critical event such as the August 2011 shock, when VIX jumped to 48. It was inevitable that VIX would both revert down through its mean just above 20 and be suppressed below that level for a period of time generally proportional to the displacement of the shock.
The same principles guide the entire volatility cycle. From the time the current high-volatility regime began in July 2007 until August 2008, there were five volatility events that occurred every two months, on average, and spiked VIX to just above 30. Since the fall of 2008, there have been two major shocks of similar magnitude (in May 2010 and August 2011) that saw VIX peak in the mid-40s and were followed around six months later by lower-intensity events. These repeating patterns and periodicities make it possible to forecast the volatility cycle with enough accuracy to develop risk-mitigating strategies.
Thankfully, while analysis of the volatility cycle could include limitless complexity, it can also be distilled down to a rudimentary rule of thumb: When VIX sustains a rise above 20, take caution. There is typically a pause in the 20-25 range that provides enough time to deploy hedges and long volatility exposure prior to a sharp VIX spike higher.
If the event dissipates, as occurred with the recent May tremor, the premium spent on protection would be nominal relative to the potential risk of a high-magnitude shock. Given the likelihood of similar volatility events over the next few years, a simple, disciplined risk framework could be the key to portfolio survival.
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