“It might be that VIX is fairly priced for the first time, and that risk is fairly low”

Last week, the volatility index hovered around its lower range. However, the low volatility phenomenon is occurring not only in the equity space, but across the board, from fixed income, to currency, to commodity markets around the world.  Still, experts are divided whether this current low volatility is pricing in the risks correctly.

Steve Heston, who developed a stochastic volatility model that addressed some of the weaknesses of the Black-Scholes model, came out with an interesting statement regarding the current volatility. He said that the VIX is fairly priced for the first time:

The VIX gauges expectations for future stock market gyrations based on prices in the options market. It represents the price the market is willing to pay to capture any profit from market movement over the next month, or three months. When the VIX is low, investors are betting that stock prices aren’t going to gain much, or lose much, over a prescribed time.

“So either options have gotten cheap because they should be cheap, because the market is not moving much lately, and it’s not expected to move, or it’s gotten cheap because people are not willing to pay as much for options, because they realize they’ve been historically overpriced,” Heston says. Read more

We don’t know whether he is correct or not. However, a graph in a Bloomberg article by Tanvir Sandhu depicted a picture that is consistent with Heston’s statement. It showed that the short interest of VXX ETN has gone exponentially in recent years.

Short-volatility strategies have performed well since 2009, just as black-swan funds were pitching end-of-the-world portfolio protection. The mindset of short-volatility sellers is characterized by expectations of preemptive central bank action to any crisis, making the trade a structural strategy as global rates hover near the lowest in human civilization. Read more

This means that investors just keep selling volatility.

Another article, by Jamie McGeever et al of Reuters, told a similar story. It said that there is little evidence of investors hedging, protecting themselves from a market correction:

Implied volatility is an options market measure of investors’ expectation of how much a certain asset or market will rise or fall over a given period of time in the future.

It and actual volatility can quickly become entwined in a spiral lower because investors are less inclined to pay up for “put” options — effectively a bet on prices falling — when the market is rising. Read more

So the question is: when volatility is low, why are investors unwilling to protect themselves from a potential market downturn?

If we use the insurance analogy, then one should buy insurance when it is cheap, and not when a disaster happens and insurance is impossible to buy.

We think the problem is that even when the volatility is low, investors still find the insurance expensive. Probably it’s just their perception.

But still, one can ask

What are the cheaper hedges?

In the next installment we will explore some less expensive options for hedging.

Further questions

What's your question? Ask it in the discussion forum

Have an answer to the questions below? Post it here or in the forum

LATEST NEWSTexas Instruments Has a Lot Riding on Auto Chip Pileup
Texas Instruments Has a Lot Riding on Auto Chip Pileup

The chipmaker’s other sectors are weakening, but it is maintaining a plan to boost manufacturing capacity to meet long-term demand.

Stay up-to-date with the latest news - click here
LATEST NEWSFitch Downgraded Nordstrom to BB+, Outlook Stable
Fitch Downgraded Nordstrom to BB+, Outlook Stable
Stay up-to-date with the latest news - click here
LATEST NEWSEnviva’s Port of Chesapeake Recognized as a “Sustained Distinguished Performance River Star Business” by The Elizabeth River Foundation
Enviva’s Port of Chesapeake Recognized as a “Sustained Distinguished Performance River Star Business” by The Elizabeth River Foundation

BETHESDA, Md. — Enviva Inc. (NYSE: EVA), the world’s leading producer of sustainably sourced woody biomass, has been recognized as a “Sustained Distinguished Performance River Star Business” by the Elizabeth River Project for its energy savings efforts, metal recycling, and increased oyster gardening programs. The…

Stay up-to-date with the latest news - click here
LATEST NEWSLayer-2 Optimism (OP) Token Soars Amid Second Airdrop Speculation: Is Growth Sustainable?
Layer-2 Optimism (OP) Token Soars Amid Second Airdrop Speculation: Is Growth Sustainable?
Stay up-to-date with the latest news - click here
LATEST NEWS2022 Year-End Indicator Details The Middle Market’s Continued Recovery
2022 Year-End Indicator Details The Middle Market’s Continued Recovery

Historically high growth rates persist with few signs of slowing COLUMBUS, OHIO — For the third straight reporting period, the U.S. middle market continues to sustain double-digit, year-over-year revenue and employment growth. Higher interest rates and the threat of inflation, however, are causing middle market…

Stay up-to-date with the latest news - click here

Leave a Reply