Volatility: Come Out, Come Out Wherever You Are

Ah, yes, a little game of hide-and-seek. Games like this intrigue us, much the same way evaluating expectations in the market captures our interest.

Is the root of the game “Hey, volatility, come out of hiding — we know you’re out there?” Or is this game asking, based on current market conditions where volatility expectations are still too high (we see you hiding in these option premiums), “Will you please just come out already?”

And just as intriguing is the answer to both scenarios is … yes.

There certainly are many possible scenarios which could manifest and push the CBOE Volatility Index (CBOE:VIX) back into the higher 20s or even 30s. However, most of these scenarios have been a constant presence in the markets for the past year, if not more.

We hear about the euro zone every day … their troubles with debt, their currency, their interest rates and so on. Yields on Italy’s 10-year notes have been hovering around 7% for the past several months. In the past, the thought of such high yields on these 10-year notes sent shockwaves through the global markets. However, as time passes, the anxieties of the unknown become the reality of the known.

What many viewed as a catalyst for market destruction has turned out to be yet another highly publicized, overhyped event that the overall markets have priced into the mix. This “wall of worry” has generated enough pricing pressure to push the S&P 500 (SPX) back up to the 1,300 level.

With the VIX trading back down to the low 20s, many market purveyors have sounded the alarm that volatility is too low, offering cheap market protection.

As shown in the chart below, volatility has come down quite a bit over the past month. One could make the case that the perceived systemic risks in the market make buying volatility attractive at these levels.   However, looking at historical or realized volatility, the latter interpretation of the question posed above could prove to be the correct interpretation.

SPX short-term realized volatility (iVolatiltiy.com’s 10-day historical: 9.78%, 20-day historical: 15.38%) has dropped dramatically over the past month and, in particular, over the last week. Stutland Volatility Group made the observation last week that implied volatility had dipped below historical. This is an unusual occurrence, and we felt it should be addressed. Apparently much of the news this week had been discounted.

Looking at the current historical volatility measures, the comparisons would indicate that the VIX has more room to drop.  So when you read all the commentary that volatility has gotten cheap and it’s time to buy volatility, relative to short-term historical volatility, it may not be as cheap as it appears.

Article printed from InvestorPlace Media, https://investorplace.com/2012/01/volatility-come-out-come-out-wherever-you-are/.

©2021 InvestorPlace Media, LLC