Back in late June I wrote an article about “the next bull market.”
At the time I said, “the VIX had just hit historic lows around 11.14 and the market was climbing towards all-time highs. Low volatility means that investors are not fearful about the future prospects of the market. And as you can see below, it is plainly evident in the investors’ fear gauge, otherwise known as the volatility index, or VIX. In fact, we haven’t seen levels this low since early 2007.”
But before I go any further, let me give you a brief summary about the VIX and how it works . . . in simplified terms.
The Chicago Board Options Exchange’s Market Volatility Index, or the VIX, measures the implied volatility of the S&P 500 index, representing investors’ expectations of volatility in the S&P 500 over the next 30 days. Higher VIX values indicate anticipation of higher stock market volatility, while lower VIX values indicate the expectation for lower stock market volatility. With stock markets tending to “take the stairs up and the elevator down,” as the old saying goes, higher volatility is associated with lower prices most of the time. So, if investors think equities are going lower, they think the move will be accompanied by increased volatility, and therefore will be willing to price the VIX or volatility higher.
Basically, low volatility reflects investors paying less for future downside protection. Paying less for downside protection means investors are less concerned about the possibility of downside . . . so low volatility means investors are becoming more “complacent.”
It’s kind of like a person foregoing hurricane insurance because there hasn’t been one in several years. Their recent good fortune of no hurricanes destroying their house has made them complacent about the possibility of future hurricanes.
So indeed, a low VIX represents a certain amount of complacency and lack of awareness of possible downside among investors in equities. And historically when we see extremes in low volatility like what we are seeing currently, a push higher is right around the corner – which means equities could experience a reprieve.
But the reprieve in equities should lead to a tremendous opportunity in volatility.
This is why, in my opinion, I think we are entering into a new bull market . . . a bull market in volatility. The question is, how can we take advantage of this new bull market in volatility?
As you can see in the chart above, we’ve seen two other instances over the last 20 years where volatility hit all-time lows only to rally for the next five to seven years. I think it is no surprise that I expect the same result this time around as well.
Volatility is back, and while most investors are fearful and more importantly, losing money, options sellers are confident and making money.
I’ll be back tomorrow with an example of how I am taking advantage of current pop in volatility.
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Here’s Why Volatility Is Our Friend
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