There are two methods of measuring equity volatility that I most often use. The CME equity volatility tools on QuickStrike, which measures implied volatility in varying duration CME options contracts, and the more commonly used, but slightly less informative VIX index.
The VIX index is a measure of the volatility component priced into S&P index options. The less formal definition is the "fear index" because of the tendency for violent spikes in declining stock markets as traders scramble for options protection during the selloff. The irony is that the protection reach usually accelerates into the end of the equity dip. It's a bit like asking an insurance company actuary to calculate the cost of fire insurance on a house that he knows was just struck by lightning and then blindly paying his price. The CME QuickStrike volatility tool is more valuable for assessing implied volatility across different expirations of futures options. This becomes extremely important in moments of intense market panic.
Volatility and the Fed Put
The VIX index has averaged 14.54 over the last five years but declined to a 11.95 average over the 18 months that ended on the last trading day of 2017. This year began with a bang that has seen two significant VIX spikes and an overall average of 15.29. Although 15.29 is well below the 18-year average of 19.75 it sure seems high relative to the placidity of the preceding year and a half.
This return to volatility has occurred mostly due to a transition to a higher interest rate environment. For many years the market has believed that the Federal Reserve would keep rates low and provide the "Fed put" to protect investors from downside risk.
If the Fed put has been removed it stands to reason that the market would be freer to move down as well as up. There are of course some secondary drivers of the return of volatility. Unpredictable trade policy coupled with the perception of political turmoil has definitely had its effect on stock prices. As it appears that these factors may be here for a while, my conclusion is that we should get used to elevated equity volatility.
Higher Highs and Long Corrections
Over the last five years there have been two times where the VIX has spiked above 40. In both these instances the low in equity markets was not established until between two and four months later. Extreme spikes can herald a reasonably long corrective phase. However, VIX spikes to a high between 18-35 have generally meant that the stock weakness was short lived and a "buy the dip" strategy was valuable.
Of course, it's tough to know immediately if the move to a VIX 25 is not the first leg of a higher move. Therefore it's not easily tradeable. Conversely, moves below an 11.5 reading on the VIX can indicate a level of complacency that will eventually lead to trouble, but these periods can be varying degrees of length making timing trades very difficult.
The lack of stock market predictive powers in volatility levels don't, however, make them a worthless tool. The true value of understanding implied volatility levels for traders is how to use them to their advantage when expressing an existing directional bias.
The CME QuickStrike tool can be used to identify spikes in different duration volatility relative to others and expose potential spread trades that benefit in the eventual reversion to the mean. Swings in volatility can be viewed as opportunities in option pricing and not as reasons to hide under the bed.
Written by Jim Iuorio. Read more from the author here.
(This article is sponsored and produced by CME Group, which is solely responsible for its content.)