2018 may only be 15 weeks old, but it’s quickly proven that it’s not 2017 anymore. Stock market volatility is well off its highs already, but it remains elevated compared to what we saw last year. So what’s going on, and what should investors do about it?
First, it’s important to be aware of the index that measures volatility, the VIX. Generally speaking when stocks goes up, volatility goes down and vice versa. It should be noted that the VIX volatility index cannot be bought or sold like a stock. However, investors can trade options on the index.
Second, it’s important to know what happened last year and in February of this year. Particularly from a volatility standpoint, as many investors big and small took part in the short-volatility trade.
The Short-Vol Blunder
Short-vol is a simple strategy that involves selling volatility and taking a long position in equities. In a nutshell, investors were nailing a double whammy. They sold short or collected a net credit on their short volatility trade while simultaneously using those funds to extract gains on a long stock position.
Consider that in 2017 the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) rose 19.4%, the PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQ) rose 31.5%, and the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) rose 25.25%.
All the while, the VIX tumbled 20%.
So you can imagine, as we entered 2018 after a strong year and tax reform just going through, why so many funds, managers and traders would stay short volatility and long stocks. In hindsight, it was only a matter of time before it blew up in everyone’s face.
And it did.
The S&P 500 fell 10% in 10 days, causing those double-whammy gains to become double-whammy pains. Losses in their long positions were exacerbated by the monumental losses traders were seeing in their short-vol positions as the VIX tripled in just a few days. It caused a painful unwind and a few ETNs to actually go under.
The plus side to all of this? It’s left us with a more-normal amount of stock market volatility.
Why Embrace Stock Market Volatility?
Currently, the VIX is trading for just $13.42 after the volatility index plunged more than 8% Wednesday. However, the long-term average for the VIX is actually $18.50.
For traders, higher volatility is exactly what they like. It allows for larger price swings over a shorter time period, giving traders more opportunity for quick profits. However, even they’d be happy just to see average volatility. Long-term investors should welcome average volatility as well. Why? It’s simple.
Did you sell any stocks in 2017 because they were overbought or overvalued, looking to buy them back at a lower price? How about waiting for a stock to come down, in order to buy at a better entry price? I know both scenarios happened to me last year.
A lack of volatility creates a fear-of-missing-out (FOMO) feeling among investors. They see a stock at $85 and wait for a pullback to $80. Then $90 comes, then $95, then $102 and finally on a pullback to $100 they pile in. It’s classic FOMO action, and it creates a really unstable environment when it goes unchecked in a low-volatility market.
Along with giving stocks a breather and investors a healthy buying opportunity, volatility also gives both bulls and bears something to do. One-sided action doesn’t benefit anyone over the intermediate term, as the “snapback” to reality hurts whichever camp had been enjoying the months or quarters of gains.
In short, just like how we don’t like to see long periods of high volatility, long periods of low volatility has its consequences, too.
Trading the VIX
I’m not too big on trading volatility products, and I’m glad that’s the case. Otherwise, I’m sure I would have been in the short-vol trade that crushed so many investors earlier this year.
Instead, just use the VIX as a reference for stock market volatility. Know that extreme levels on the VIX — both on the upside and downside — can be another factor when formulating a thesis on when to buy or sell.
Depending on the circumstances, investors can also use periods of high, unsustainable volatility (such as in February) to add to their long positions, as the market is generally in a fearful and irrational state.