Expectations for volatility over the next 30 and 90 days are measured by the CBOE’s volatility indexes, respectively. These indicators evaluate index option prices, bid-ask spreads, interest rates and a few other factors to make an annualized expected volatility estimate for the S&P 500.
Due to the Volatility S&P 500 (VIX), new traders often assume that it would be a great tool for channeling trading strategies. Unfortunately, VIX derivatives (exchange-traded funds, options, futures) don’t work like the index does. So, they get burned quickly. However, the underlying concept of “buying volatility” when it is low is still compelling and could be used to find some interesting trading opportunities with the right instruments.
For example, investment-grade bonds (those rated BBB- or better by Standard and Poor’s) have a strong positive correlation with the VIX. While it isn’t perfect, the two asset classes will often spike or decline at the same time.
Rising volatility expectations are a little bearish for stocks although it may take a while before stock-sellers really hit the market. However, if traders are worried about rising risk and volatility in stocks, they are likely to rebalance a little into safer assets like bonds. If the VIX is forming a series of higher lows over time, we would expect bonds to be also trending positively as well, even if stocks have been doing well.
That scenario is basically what has been playing out through the last half of 2014. As you can see in the next chart, the VIX has been forming a series of higher lows indicating that confidence in stocks is eroding. Each time market expectations improve, prices will rise, but traders get a little more cautious. Some of those profits are reallocated from stocks to bonds, and we would expect bond prices to be rising as well, which you can see in the chart of the iShares Barclays Aggregate Bond Fund (AGG).
Volatility S&P 500 (VIX) vs. iShares Barclays Aggregate Bond Fund (AGG)
Since the market started to rally in October, bonds cooled off from their panic-highs and then began to slowly rise again on Oct. 6, 2014. Since that time, AGG’s trading range has been unusually tight. I also applied a Bollinger Band® study to the chart, and you can see that the band’s width is narrower than it has been since August and January of 2014, before two other positive breakouts.
Technicians call it a “squeeze” when the Bollinger Bands® narrow like this. A breakout is usually inevitable, but which direction is uncertain. One way to approach this opportunity is to trade in favor of the first close beyond one of the bands. In this case, our expectations are that volatility is likely to increase again, which is good for bonds. The bands are currently very narrow. So, a close breakout above the upper band could occur in the short-term.
You can see a close-up of this trade setup on Jan. 10, 2014 in the next chart. This technical setup is effective because Bollinger Bands® are a type of volatility indicator themselves. They are set two standard deviations away from the 20-day average price. Essentially, when 95% (two standard deviations) of the closes over the last 20 days fit within a narrow range like this, it increases the potential for an explosion of volatility. Due to the short-term setup, we would only recommend entering a long-term position if the squeeze breakout were to occur in favor of the long-term trend.
iShares Barclays Aggregate Bond Fund (AGG)
Some investors may wonder why we would recommend a long position on a bond ETF rather than shorts on the S&P 500 itself or a long position on a VIX derivative. Sometimes a short position on the S&P 500 would be the right choice, but because bonds have been trending with stocks recently, we think this provides for a more likely positive outcome. Unfortunately, VIX derivatives rarely work as expected. They are expensive, and VIX ETFs are particularly toxic for positions held longer than one day.
Because it isn’t a forgone conclusion that the market will flatten or drop and volatility will increase, we recommend managing a conditional order for this trade. A close through the upper band should signal a new long position once volatility is starting to escalate. We think that is likely to happen during Thanksgiving week. However, sometimes holidays can be somewhat stagnate, and so, a signal like this may not occur until the first week of December.