E 2018 Market Volatility And Volatility Trading Update

Investor Sentiment

This year has been a year unlike more recent and years whereby the markets trended steadily higher and were somewhat predictable. No, 2018 has been found with lesser investor confidence and enthusiasm post the January period where the tax cuts/fiscal stimulus was otherwise priced into the market. A recent read on institutional-investor confidence has come down sharply this year, according to the Wells Fargo Investment Institute, a change largely to the trade related tensions between the U.S. and the world.

According to the AAII Investor Sentiment survey (July 6), the percentage of investors who describe themselves as bullish, meaning they expect stocks to be higher in six months, fell to a three-month low in the latest week. Only 27.9% of those polled are optimistic, well below the 38.5% historical average, and at a level that AAII described as “unusually low,” meaning it is one standard deviation below the long-term average.

The ratio of bearish investors stands at 39.3%, notably above the long-term average of 30.5%, but down 1.5 percentage points from the previous week, when it was at an unusually high level. Nearly 33% of investors describe themselves as neutral on the market; this reading has been above the historical average of 31% for 20 straight weeks, a sign of how mixed investors are about Wall Street’s prospects over the rest of 2018. Fortunately, the most recent AAII  Investment Sentiment survey showed marked improvement from the July 6th reading. 

So here’s the point with regards to investor sentiment: There’s less confidence in equity prices moving higher. Conversely, the indicators or readings on investor confidence are often used as contrarian indicators. In other words, one might consider buying when confidence is low and selling when confidence is high.

Headwinds vs. Tailwinds

More importantly as it pertains to 2018, the lack of investor confidence is indicative of the markets inability to break to the downside or the upside as investors continue to weigh the pros and cons. And there are a great many pros and cons that are offsetting in 2018. Take a look at the following table of pros and cons presented by Charles Schwab that identifies the headwinds and tailwinds for market participants.

That’s why it has been so difficult for the market to gain traction and why the markets have been stuck in a range for the better part of the last 4 months. At some point, the market will make a decision, for better or worse.

Moreover, the market has found itself with increased volatility for the aforementioned reasons and variables. Where 2017 found the average VIX reading at just above 11%, 2018 has found the VIX some 35-40% higher than the prior year. The median VIX in 2018 thus far is 15.78% and the highest median value since 2012 where the median VIX reading was17.52.

2018 Volatility Trading

Before we begin discussing trading volatility, here are some important basic fundamentals and principles about the VIX.

  • The VIX is priced from a portfolio of S&P 500 (SPX) options defined by the CBOE, and the futures price from the market’s expectation (Implied Volatility) of where the VIX Index will settle at expiration. One component in the price of SPX options is an estimate of how volatile the S&P 500 will be between now and the option’s expiration date.
  • This estimate is not directly stated, but is implied in how much buyers are willing to pay.If the market has been expressing great gyrations, option premiums will be expensive. To the contrary, in a quiet market they will be cheaper.
  • The moves of the VIX track prices on the SPX options market, not the general stock market; this is a key point.The SPX options market is large, with a notional value greater than $100 billion, and is dominated by institutional investors. A single SPX put or call option has the leverage of around $200K in stock value, too big for most retail or independent investors.
  • The VIX Index, often referred to as “spot VIX”, is simply the implied 30-day volatility of S&P 500 options.  To calculate 30-day implied volatility of S&P 500 options, a weighted average of implied volatility across a range of puts and calls (strangle) is taken such that the resulting weighted average represents synthetic 30-day implied volatility.

Golden Capital Portfolio (which I manage, at Finom Group) is focused on a VIX investment strategy and has been since 2012. In 2018, given the longevity of the current economic cycle (expansion) and relative complacency in the markets found in 2017, it was expected that market volatility would elevate. I warned investors in 2017 with the publication titled Short Volatility Strategies And A Word Of Caution. In it, I warn of the usage for certain VIX-ETPs, notably SVXY and XIV. Unfortunately, the warnings proved all-too prescient.

Additionally, every year, volatility is expressed uniquely in the market. For example: 2017 was a short-every-VOL-spike-to-death year for volatility, no matter how big or how small. And that’s exactly how the year played out. In general, shorting VIX spikes go hand-in-hand with the efficient market hypothesis even though it’s never considered to be. In fact, this might be the first publication offering such a VIX correlation to the efficient market hypothesis.

In 2018, we characterized and forecasted for higher volatility in the markets. In an e-mail to Golden Capital Portfolio investors we named 2018 VOL trading long-against-the-box or LOB. The following screenshot is from the Golden Capital Portfolio annual letter to investors that detail thoughts on VOL trading in 2018.

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