Market Correction Sows Seeds for Short Volatility Plays

by Tyler Craig | May 8, 2012 12:08 pm

Market Correction Sows Seeds for Short Volatility Plays

Views on volatility vary across the spectrum. The lion’s share of long-biased investors quickly associate the “V” word with shocks to their emotional psyche and otherwise painful financial drawdowns. Volatility has long since been lumped into a rather unsavory group of lepers and plagues that are altogether shunned by the masses.Rather than flying solo, volatility has a well documented history of appearing hand in hand with bearish price action.

And therein lies the source of its widespread disdain. Since it inevitably materializes in the midst of market corrections, volatility is associated with all sorts of hobgoblins that haunt the dreams of the everyday buy-and-holder.

Suppose we hijacked the ubiquitous Facebook “Like” button and linked it to the price movements of the S&P 500 Index. Everyday investors could select the button to express their affection toward current market movements. No doubt, the likability of Q1 2012 would have been through the roof.

In contrast to the docile bull that wooed participants last quarter, the past few weeks we’ve seen another less friendly character take control of the markets, leaving many reaching for their dislike buttons.

On the other side of the aisle are a few addle-brained investors welcoming a resurgence in volatility. I count myself among their ranks. Such a welcoming attitude stems from two things. First, every volatility rocketship that has ever launched eventually succumbed to the inevitable pull of gravity.

While the CBOE Volatility Index and the slew of tradable products associated with it are rising in the short term, their long-term return to earth is all but assured. On the backs of every volatility ramp lies a return-to-normalcy trade. A trade that, by the way, can’t exist without the occasional deviations from the mean, the sporadic forays into the abnormal.

Craig Volatility 5 8 300x179 Market Correction Sows Seeds for Short Volatility Plays
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Source: MachTrader

Second, with the last major upset to volatility having largely played itself out, we’re in need of another lift. I’m speaking in particular of the multi-month fall in the VIX, OVX (crude oil volatility index) and GVZ (gold volatility index) that has taken place since the July-October correction last year.

For example, I track a couple of short volatility strategies on the U.S. Oil Fund ETF (NYSE:USO[1]), and it was virtually impossible to find a trade I liked for May because volatility was so depressed. The ongoing free-fall in oil prices along with a rise in OVX will do wonders for reinflating premiums in USO. Short puts in particular will be a much more attractive play once the selling pressure in USO abates.

At the time of this writing Tyler Craig had no positions in any of the securities mentioned.

Endnotes:
  1. USO: http://studio-5.financialcontent.com/investplace/quote?Symbol=USO

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