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Volatility Is Dangerous for the Markets

There are many things that are driving this view. The economy is sluggish and the main barrier to growth is unemployment, which is stubbornly high. We have the "fiscal cliff" situation that, if not resolved, can potentially slow the recovery. The European recession is in full swing and there is some risk of a breakdown of the European monetary union. The on-again, off-again crisis in the Middle East in Syria and, more significantly, the confrontation with Iran can drive even more uncertainty in the world markets.

In addition, the implied volatility is low as well. The implied volatility has many explanations: There is the fundamental financial definition that says it is based on today's option price of the S&P 500 index, from which the future (or implied) volatility can be derived using the Black Scholes option pricing model.

But, more commonly, implied volatility is called a fear factor or, as some contrarians call it, the complacency factor, depending on your own perspective of the market. We even have a well-established index that tracks this; the VIX, which is the 30-day derived (implied) volatility based on current S&P 500 option pricing.

Even if you look at the VIX chart, you can see how low, relatively speaking, is today's implied volatility. The chart also illustrates how the fear factor is always opposite of the booming market: When the market is going up, the fear factor (i.e. the VIX) goes down, and when the market is going down, the VIX goes up.

Looking at both charts, we could conclude that investors are confident of the future market direction and, despite many domestic and global uncertainties, they don't foresee major market gyrations in the near future.

That, of course, can be the end of the story. Unfortunately, it does not satisfy my own curiosity, nor does it allay any of my risk-averse fears. Fortunately, there is another way of looking at volatility, which may provide some answers to us, or at least allow us a glimpse into the future.
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