Volatility can be your friend
Tuesday, 22 January 2019
By Murray Dawes
- Three decades of volatility
- ASX 200 daily sell pivot after IMF growth projections
I have been rabbiting on about the current state of the market and the risk of more selling coming soon. If you are an investor or trader the next question becomes ‘So what can I do about it?’
There are plenty of ways to approach the problem of how to either lower your exposure or create positions to take advantage of the coming volatility.
Today I’d like to focus on the VIX contract.
VIX as you are probably aware is a calculation of the current 30 day implied volatility of S&P 500 Index options. It is known as the fear gauge because it reflects the current volatility of the market and tends to fall during calm periods and oscillate wildly during volatile periods.
You can trade the VIX as a contract and even trade options on the VIX, so as a method for hedging current exposure to the stock market it can come in handy. It can also be used to create outright positions trying to take advantage of an expected rise in volatility.
Three decades of volatility
Click to enlarge
When looking at the long-term chart of VIX I can’t help but see the distinct separation between low volatility periods and high volatility periods.
This is a monthly chart of VIX going all the way back to 1990. I have added a 10 period exponential moving average (EMA) over the top of chart which is the thick black line that moves with the VIX prices.
The ‘line in the sand’ that I have added is at a VIX level of 16.0. While the 10 period EMA holds below the ‘line in the sand’ I consider the market to be in a low volatility environment.
Have a look at the chart and notice the clearly defined periods of high and low volatility over the past 30 years. A high volatility period lasted for eight years from late 1996 to late 2004. Then again from mid-2007 to mid-2013. That’s another six years in a row of heightened volatility. We saw a short period of heightened volatility during the 2015–16 market sell-off before volatility plunged again between mid-2016 to December 2018.
In December 2018 the 10 period EMA of monthly VIX prices once again headed above 16.0 for only the fourth time in 30 years. Will this period last between six to eight years like the first two? It’s possible.
More after the markets…
The US markets are currently closed for Martin Luther King Junior Day.
In Europe, the Euro Stoxx 50 index finished down 9.85 points, or 0.31%. Meanwhile, the FTSE 100 gained 0.032%, and Germany’s DAX closed down 69.34 points, or 0.62%.
In Asian markets, Japan’s Nikkei 225 is down 141.30 points, or 0.68%. China’s CSI 300 is down 0.87%.
In Australia, the S&P/ASX 200 is down 36.60 points, or 0.62%.
On the commodities markets, West Texas Intermediate crude oil is US$53.44 per barrel. Brent crude is US$62.26 per barrel.
Turning to gold, the yellow metal is trading for US$1,278.68 (AU$1,791.32) per troy ounce. Silver is US$15.21 (AU$21.31) per troy ounce.
One bitcoin is worth US$3,553.06.
The Aussie dollar is worth 71.38 US cents.
When analysing the periods of heightened volatility there are a few interesting points that can be made. It is pretty rare for VIX to trade below 12.0 during these periods (The black dashed line below the ‘line in the sand’), and when it does it is often a precursor to a shift from a high to a low volatility period.
Also it can be noted that the area between 12.0 to 16.0 is usually good buying with volatility usually picking back up from that zone.
Another interesting thing to point out is that a very high volatility period is usually short lived. VIX can spike up to a level of 30.0 to 45.0 over and over again during heightened volatility periods, but then the volatility usually subsides quite quickly and VIX falls rapidly back to the 12.0–16.0 zone before building up for another spike at a later date.
I have placed a red dashed line at the level of 30.0 so you can see how often prices hit that level during high volatility periods.
One way of looking at how VIX prices act once they hit a level around 30 is that they become extremely volatile from that point. I.e. they will either continue spiking higher rapidly and will top out around 45.0 in most cases or go completely nuts and hit 96.0 like during the crash. Or they will plummet rapidly back to the 12.0–16.0 zone.
How can we use all of the above to come up with a strategy for using the VIX to lower our risk or gain exposure to a period of high volatility? [All that follows is just a discussion about potential strategies to get you thinking, it is not a recommendation to be executed now. My own trading model hasn’t sent any signals yet that I need to enter such a trade.]
Obviously getting long VIX in the 12.0–16.0 zone is the first step with a stop loss below the 12.0 level.
My own method for choosing the time to buy VIX will be based on my technical analysis model. When I think there is a high probability of seeing a correction in prices after a low volatility period I will aim to buy VIX within the 12.0–16.0 zone.
The added piece of the jigsaw that you may not have thought about is buying VIX calls with a strike price of 30.0 and then creating a straddle once prices hit 30.0 by buying puts against the calls so you are exposed from that point on to volatility either spiking or collapsing.
You would exit the long VIX position once prices hit 30.0 or thereabouts, safe in the knowledge that the calls you have will take over the heavy lifting from that point.
By creating a cheap straddle with a strike of 30.0 you gain exposure to either a large spike in volatility or a return to normal trading.
A more conservative trader might choose to buy the 25.0 calls in order to increase their chances of getting set in the straddle, but the cost of the options would of course go up.
If I were to consider following such a strategy I would have to commit to it for a prolonged period by buying another set of calls, as the old ones expire for a period of at least 9–12 months, so I had the best chance of getting a good payoff.
The June 30.0 calls for example are currently trading at a price of 0.80 points or USD$800 each. So I would be planning on buying the June calls and rolling them over into December calls if necessary.
But again just to make it clear, I don’t have any signals to execute this trade right now. I am waiting on further confirmation before doing anything so this is not a recommendation.
Hopefully the above discussion has at the very least got you thinking about the fact that there are many ways to skin a cat when faced with the uncertainty of the market.
ASX 200 daily sell pivot after IMF growth projections
The market is in far too jittery a state to weather much bad news. We have seen a sharp rally back into heavy resistance so any momentum shift from here is potentially hazardous.
The news that the IMF has lowered 2019 global GDP growth projections to 3.5% from 3.7% as of October, is another sign that things are rapidly coming off the boil around the world.
In yesterday’s update I said that I expected to see some selling eventuate around these levels and that a daily sell pivot was what I needed to see first to indicate a potential shift in momentum.
If the ASX 200 closes below 5879 today (currently 5862), we will have a daily sell pivot confirmed from the sell zone of the last major wave down in this downtrend. A short sharp sell-off of about 200 points could be expected in the near future. Whether or not that will be it and the buying will return is anyone’s guess, but the risk is firmly to the downside based on the long-term technical picture which I outlined to you the other day.
To recap, while a quarterly sell pivot remains in place we should expect to see lower prices ahead. This rally should be seen as an opportunity to lower exposure or look for ways to get short.
This whole process may still have many months to play out and I wouldn’t be surprised to see some selling now reversing course over the next few weeks with higher prices eventuating. But the big picture is set in stone. As long as we remain below the highs achieved last year the bears should remain in control.