Why Has Volatility Declined So Much?
Volatility is considered a trader's friend, yet the trend has been pointed down for months. What's a trader to do? Does this mean all is fine in the world, nary a worry? Hardly so, but the short term unknowns have been revealed and the market is saying 'rock on'. All we need to see is the chart to make that determination (see below).
But if the weak US economy and fiscal cliff are dead-ahead along with the uncertain election, China slowing down and may have to cut their growth estimates again, then Europe with the high sovereign debt crisis. All of these issue are known, no surprises here. The outcome of course is the big wildcard, how will investors/traders react to an 'event'. Today's market shows the majority are ignoring any warning signs - and that's not all bad.
Let's step back a bit. Why does a trader/investor need to buy protection? Much like buying insurance for your car, house, boat or health..investment gains need to be protected. Markets do not go up in a straight line and when there is uncertainty it is smart to reach for insurance. In fact, a long portfolio that gets long some volatility will actually dampen the overall beta, and hence portray less overall risk vs the market.
The VIX is near the lowest levels of the year. While that could be trouble to some, we recognize the uncertainties have been lifted. There have been times of low volatility for months, and while the yearly low is probably NOT a good place to put on new bullish positions, the absolute number should not be too scary. We know what the Fed is going to do; there is no time limit rather it's about seeing better numbers on employment, we know what the plan is in Europe, ECB Chairman Draghi has told us (multiple times!) it will be managed.
Option prices are low (relatively speaking), the term structure of VIX futures is steep (which portrays a bullish trend) and the wall of worry is up (see chart). Strikingly, the term structure of the VIX is similar to that of the term structure of interest rates in terms of shape and slope (see chart). Simply put futures buyers are paying up for protection into the outer months - a normal condition in a bullish market.
China has brought out some massive stimulus programs (more may be on the way), and the rest of the world continues to promote an easy money policy. The US economy is not drifting into a recession, but it may be ready to pivot from sluggish growth to a more acceptable level.
Historically, a low VIX means it is cheap to buy insurance. Is it a bad thing to buy some cheap insurance? In case some 'black swan' event or' divine' intervention occurs it is not a bad thing - we'll always have these opportunities to buy protection but they won't always be so cheap. Got gains on a long portfolio? Now may be a good time to protect the house!