I’ve always been fascinated by the concept of “volatility.”
When I say “always,” I don’t really mean “always,” but for at least the past decade or maybe a bit more.
Volatility is one of these things that is really hard to comprehend, even though it really shouldn’t be, even as it is applied to stocks and stock markets.
Volatility is nothing more than what is defined by an equation.
Even if that equation may be a complicated one, there is something that should be comforting about the certainty of it and its calculation. There is no art to it.
It is all about science.
Subjectivity versus objectivity.
Emotion versus cold, hard facts.
Volatility is simply the result of an equation that measures “variance,” which as everyone who has taken an elementary course in statistics or bio-statistics knows as being itself related to the more commonly recognized expression: Standard Deviation.
Who am I kidding? No one recognizes that expression, or if they do, it’s been misinterpreted when I’ve used it sitting at an out of town bar, trying to strike up casual conversation with someone far younger and far more attractive than me.
Anyway, there is lots of confusion over what volatility represents and I’m confused by it, as well, even as I think that I understand it.
The confusion really enters once a marketplace for volatility had come into being.
An equation is one thing, but being able to buy, sell, sell short and sell options on volatility brings all of the emotions typically seen in stocks, now being reflected in these pieces of paper.
Actually, there isn’t even a piece of paper and if there is, Credit Suisse may be able to confirm that the product may not be worth the paper that it’s prospectus was written upon.
Fear, greed and fear of missing out now all go into the measure of volatility that we see on a second by second basis.
The equation, which should be primary, is now more of a junior consultant.
There is so much talk about volatility as a “fear indicator” or as a measure of complacency, as I discussed a number of years ago in a more thoughtful article that appeared in Seeking Alpha, that itself was in response to a nice article by Doug Kass.
So read either or both of those articles or neither or one of those articles.
But after about 4 years of insanely low volatility something interesting started happening a few weeks ago that I took note of and has only happened a handful of times in the past 5 years.
That is, there was a breakdown between the usual relationship between volatility, which I like to follow by the price of the imperfect Exchange Traded Note, the iPath S&P 500 VIX (VXX).
It tends to move in a direction opposite of the S&P 500 (SPX), but every now and then, it doesn’t do that.
Every now and then the S&P 500 may go up in a big way or down in a big way and the VXX follows when it should move much further away.
When that happens, there is usually something brewing.
The problem is that it could be brewing in either direction.
The above chart, taken as a mere snapshot in time during the course of the past 6 weeks shows some of that disconnect, as well as some of the typically expected behavior.
From about January 16th to January 22nd, the movements in opposite directions were precisely what would have been expected, although the relative magnitudes may have been less than expected, but more on that, later.
Of note, however, the continuing sharp move higher in the S&P 500 beginning on January 10th failed to have follow-through in VXX, as that climb continued on January 11th.
Curiously, VXX flattened and then started a precipitous climb higher, well out of typical leveraged proportion to the slightly downward move in the S&P 500.
For those keeping track, you know what happened by the end of January, as the market quickly went into correction mode, albeit for an incredibly short time.
Did a momentary breakdown in VXX provide a signal?
Not to belabor things, but take a look at the relative actions of the S&P 500 and VXX in the early days of February:
On February 5th, VXX reacted in a fairly muted manner in response to a 2% gain in the S&P 500. The following day, however, VXX climbed markedly higher, despite only a 0.5% decline in the S&P 500 and then exploded higher the following day.
More recently, and all of this has been happening over the course of the past two weeks, the VXX hasn’t been moving as much, especially during some of these strong moves higher in the S&P 500, as you would have expected.
Volatility, in other words, has been holding it’s own. Fear has not withered in the face of bullish optimism.
While there has been recent volatility in the S&P 500, witness the variation and daily and intra-daily swings, the VXX has been reasonably stable.
In general, the movements in VXX are of a multiple to the movements in the underlying index.
Leverage, if you will, but not right now.
To me, that speaks of more of a disconnect between the S&P 500 and the measure that is meant to track variance in a very objective way.
That breakdown is the by product of emotion.
Now, go and read my 4 year old article I referenced earlier about the role of emotion.
But, the important thing is that, thus far, despite the market having recovered much of what it lost since January 30th, the VXX hasn’t retreated anywhere near as much as one would have expected, if one was ever thinking about such things.
As a seller of options, that concept of leverage should be a familiar one.
The buyer of what I am trying to sell seeks to leverage their investment, while I seek to only add a percentage or two to my return.
The past few years have been kind to the option buyer, particularly as they have had to pay relatively little for those options and prices have generally moved higher, often delivering trading profits.
Now, with a return of volatility, those premiums are moving higher and the certainty of a profit is diminishing, even if the secular trend continues to go higher.
Even as we sit near all time highs, volatility is telling me that this may be a very good time to accumulate some cash, not necessarily out of fear, but out of the reward that comes with uncertainty.
My investment horizon has been shifting to a longer term one as I tire of daily watching of the tape and daily trading and am ready to truly enjoy retirement.
The reward of a longer term approach as volatility seeks to re-assert itself may be especially apparent with safe dividend paying stocks and I expect to make my newly assembled cash reserve take advantage if volatility continues to lead the way.