Volatility emerged again last week, and the latest crease of news that has disturbed the calm was sparked by news of serious financial deficiencies at one of Portugal’s largest banks.
When emotions are on an even keel, trouble at a Portuguese bank would not even make the back pages of the Wall Street Journal. But the latest headlines have caught investors’ collective unconscious at a vulnerable moment, inducing fears of a renewed contagion effect similar to the credit crisis that shook the region three years ago.
You can’t rely on mere financial data to understand the propagation of fear and anxiety, as it is prompted and carried forward in sublingual ways. It’s kind of like when a friend starts crying during a movie that isn’t really sad or scary, and you’re not sure why. Something triggers a memory, and suddenly they’re a mess.
In this case, the Portuguese bank situation is about as scary as a “Muppets” movie, as there are numerous back-ups in place to support the weakened institution — but the situation made everyone remember that eurozone policymakers never dealt with the 2008 financial crisis as effectively as their U.S. counterparts, and one or two wrong turns could unravel the system again. I suspect that the European Central Bank will manage to come up with some language that duct-tapes the problem for another few months at least. That’s been the pattern of late; not sure why it would change right now.
For our purposes, the key impact of the recent turmoil has been felt in the S&P 500 Volatility Index (VIX), which rose 20% in the past five sessions to go along with a decline in the S&P 500 of around 1%. This suggests that investors are about 20 times more worked up about the potential for a decline in the benchmark index than they should be. That is par for the course, and why it’s possible to regularly find an information arbitrage opportunity in the VIX.
The Portugal event by itself may not be meaningful, but investors are seeing it as a head’s up that markets have become complacent about the financial risks that remain in the periphery of the eurozone, where hedge funds and governments have exposed themselves to a lot of risk by gorging on the distressed debts in the expectation of a big rebound over the next few years.
I am talking about this because it’s a reminder of how interconnected all of the global markets are today. Events in one region may affect the decisions of hedge funds and governments in other markets, even if there is no economic or financial reason for it. And this idea percolates unseen through the minds of traders in the S&P 500 and the Russell 2000, causing them to act in ways that push those instruments and the VIX in directions that don’t make a lot of sense when observing them rationally in isolation.
The CounterPoint Options system is designed to help traders distinguish between persistent volatility events and ones that are likely to be flashes in the pan. At present, the system is largely looking for volatility to abate and stock indexes to rise, and therefore is recommending a bearish stance on the VIX. That might be counter to the current conventional wisdom…but as any active trader knows, investor sentiment can pivot in the blink of an eye.
So again, the CounterPoint Options system expects that the VIX will soon return to its persistent lows — and you’ll be well-positioned to profit from that shift if you put on the following trade now. Its recommendation is for a put option on a VIX-based exchange-traded note, the iPath S&P 500 VIX Short-Term Futures ETN (VXX).
Buy the VXX Aug. 16th $28 puts at current levels (around $1.80), and set up to sell at target $3.00, for a short-term gain of 66.7%.
Jon Markman operates the investment firm Markman Capital Insights. He also offers a daily trading advisory service, Trader’s Advantage, and CounterPoint Options, a service that helps individual traders make steady, consistent profits with volatility-related instruments.
Follow Jon Markman at Google+.