Volatility Comes Creeping Back: But Why?

High Volatility, Strategies, Technical Analysis

See why the next two weeks could be some of the most turbulent that we have seen since before the US presidential election. The markets could dramatically swing in either direction, but with the trade shared in this article, you can profit either way.

We’re seeeing something in the stock market weseeingt seen since the US presidential election took place last November – volatility. Now, we’re not talking extreme Lehman-Brothers-collapse type of volatility, but there’s defiitely more uncertainty in the the financial markets than we’ve had in months.

How can we tell? Just look at the chart of the S&P 500 Volatility Index, more commonly known as the VIX. The VIX measures investor fear (because it goes up when people buy options to protect their portfolio). As you can see, the VIX is up around 16, a 5-month high, and far higher than where the index has been for almost all of 2017.

By the way, 16 also happens to be the long-term median of the VIX. You may have heard the long-term average of the VIX is 20, and that’s entirely true. But, that’s the average, which is skewed by extreme results (such as the near 90 level we saw when Lehman died). The median is the “middle” level of the index over time and isn’t skewed by extreme results as much as the average. So, we’re sitting at the long-term median of the VIX, which means anything higher and we could rightfully consider the market more volatile than normal.

So… why is volatility higher? And more importantly, what does it mean to us?

First off, let’s take a quick look at the VIX term structure. What’s the term structure? The VIX is an index based on derivatives and isn’t actually tradeable itself. However, VIX futures and options trade based on the index. The term structure is a depiction of how the different futures are currently priced from the front month (April) on out, (all the way to November).

Now what you see above is not normal. That’s a VIX term structure in backwardation – when the front month is priced higher than the back months. Normally the VIX futures curve is in contango – when each month is cheaper than the month after it (like how May through November are priced right now). (Contango is usually the case with the VIX term structure because farther out time periods are typically considered more uncertain than the closer months.)

If you were to ask the general question of why volatility is elevated, the answer would be concerns over geopolitical risk. However, we can get a lot more specific with the reasoning. You see, we know because of the shape of the VIX term structure that there is real concern over the market conditions in April, but after that, the risk is quite a bit lower.

What happens in April that’s got everyone so concerned? The French Election. Yep, because of the unexpected results of the Brexit vote and the US presidential vote, investors are a lot more concerned about the upcoming French election than they’d normally be. More specifically, there’s concern the far right political party in France could gain unexpected power, and further muddy the political relationships in Europe and elsewhere.

Once the election is concluded, investors more or less believe market conditions will return to normal. The degree of backwardation we’re seeing between April and May is the degree of uncertainty surrounding the French election.

Okay, so how can we trade this unusual situation?

Well, there are basically three things we can do here. We can sell April VIX (as long as the contract expires after election), we can buy May VIX, or we can do both.

Selling late April VIX would be the move if you think volatility will collapse once the election takes place. If you feel the election is likely to cause even more volatility after the results are in, buying May is the right strategy. Finally, if you believe both scenarios are equally likely (to some extent) you can do both.

Regardless of what you choose, I recommend trading actual VIX futures and options instead of exchange traded products (ETPs). ETPs won’t let you buy or sell specific months, but rather a blend of different futures contracts across the term structure, making it harder to pinpoint your strategy.

For that matter, I’d forego trading futures unless you’re a regular futures trader. Stick to VIX options in this case. You can either buy calls or puts outright or use vertical spreads if you want to lower your entry price.