What is volatility, what determines it and how to invest in it. But should you?
In this episode you’ll learn:
- Why extreme events undermine the average.
- What is the VIX volatility index.
- Why the tightening of credit conditions contributes to higher volatility for stocks and bonds.
- How the demand to sell volatility is keeping volatility low.
- What to consider when investing in VIX.
To learn more about investing in VIX ETFs, check out this helpful guide.
Ten years ago, Nassim Nicholas Taleb published a book that changed my life. It was titled “The Black Swan: The Impact of the Highly Improbable.”
At the time, I wrote on my personal blog that, “the book eloquently and systematically makes the case for why my chosen profession [as an investment manager] is based on a “great intellectual fraud.”
“The fraud is the ‘bell curve,’ and as it applies to modern finance the leap of faith we take that expected returns for asset classes can be neatly plotted around an average with a precise measure of variability (risk) denoted by the standard deviation.”
“All the while we ignore the fat tails, or Black Swans as he calls them— unpredictable, rare and extreme events that not only skew the average but make the concept of average meaningless because the Black Swans change the game entirely.”
“After the fact, we create narratives to explain why the extreme event took place so that we can watch out and protect ourselves from such unpleasantness in the future.
Unfortunately, the next Black Swan is usually something that wasn’t even on the radar. We don’t know what we don’t know.”
“Much of what Taleb writes I’ve learned the hard way over the past decade. I used to think certain investment managers and corporate leaders were smarter than everyone else, only to find that they too had no clue and were buffeted by the unexpected.
Now I manage money by refusing to put faith in experts, keeping costs low, maintaining extreme diversification in order to avoid company level Black Swans, and staying humble. It’s called winning by not losing.”
“Yet what I find disturbing about the book is not just its ramification for investing, but the role ‘Black Swans’ have played in my life to date and the significant impact they will have on my future.”
“So often we look back and create a narrative for our lives. We selectively remember things while conveniently forgetting others.”
“We attribute too much of our success to our own skill and not enough to the kindness of others or just to plain luck.”
“At this point, I have no conclusions. I plan to reread the book while in France next week.”
I then left for a ten-day trip to France and Amsterdam with my nine-year-old daughter Breanna, carrying with me my hard-backed copy of The Black Swan.
Amidst the museums, castles, and poppies and on the beaches of Normandy I thought about that book, and what I could do to implement the principles it taught.
In the book’s introduction, Taleb wrote, “So I disagree with the followers of Marx and those of Adam Smith: the reasons free markets work is because they allow people to be lucky, thanks to aggressive trial and error, not by giving rewards or incentives for skill. The strategy is, then, to tinker as much as possible and try to collect as many Black Swan opportunities as possible.”
Taleb doesn’t mince words. He is direct and can come across as a bit haughty.
One thing I did while in France as part of my personal tinkering was buy some options on the VIX volatility index which was then sitting around 13.
The Buttonwood column in May 20, 2017 edition of the Economist describes VIX as follows:
“The value of the VIX relates to the cost of insuring against asset-price movements via the options market. An option gives the purchaser the right, but not the obligation, to buy (a call) or sell (a put) an asset at a given price before a given date. In return, like anyone buying insurance, the purchaser pays a premium.”
“The price of this premium is set by supply and demand, reflecting the views of the purchaser and the person who sells, or writes, the option.”
“Volatility is also very important. If an asset is doubling and halving in price every other day, an option is much more likely to be exercised than if its price barely moves from one trading session to the next. No one knows what future volatility will be. But if investors are keen to insure against rapid market movements, then premiums will rise. This “implied volatility” is the number captured by the VIX.”
VIX specifically is the implied volatility priced into options on the S&P 500 Index, a measure of U.S. large company stocks.
My experiment worked out as by year-end of 2007 the initial signs of the Great Financial Crisis were evident and VIX had risen to 20. I cashed out my options with a healthy profit and felt smart, but the reality is I was lucky. I didn’t have any foresight that implied volatility would rise.
Christopher Cole, founder of Artemis Capital Management, an investment firm that seeks to generate returns from market volatility, said on Grant’s Podcast that “Low volatility is not a good reason for volatility to increase.”
When I purchased an option on VIX that was my thesis. Implied volatility is low so it only has one way to go: up.
Cole explained, “Volatility tends to cluster. Low volatility tends to predict low volatility. And high volatility tends to predict high volatility.”
So if I was following historical trends, I should have sold options on volatility instead of buying them. And I should have been looking for signs that indicate volatility would increase.
Why Volatility Increases
Cole gave a brilliant explanation for why volatility increases.
He said, “Volatility is the brother of credit. And volatility is driven by regime shifts in the credit cycle. And if we just think about fundamentally what volatility is. Vol derives from an option on shareholder equity, but equity itself can be thought of as a perpetual option on the future success of a company. “
“So when times are good and credit is easy, a company can rely on the extension of very cheap debt rather than equity to support its operations. And as a result of that, cheap credit makes the value of equity less volatile. Simple enough. It’s just very simple.”
A regime shift in volatility is caused by a tightening of credit conditions, which we can be observed by looking at the incremental yield investors demand to hold corporate bonds relative to government bonds.
Higher credit spreads, such as for non-investment grade bonds, are highly correlated with higher volatility for stocks and bonds.
Lightening Strikes and Steamrollers
Tim Hayes, Chief Global Investment Strategist at Ned Davis Research put it this way, “In most cases, lightning doesn’t strike from a blue sky. More often, deteriorating fundamentals lead to a gradual transition from risk appetite to risk aversion. The fear of lightning is more rational when storm clouds are already darkening the sky.”
So until credit conditions deteriorate, the economy slows and companies are not as readily able to borrow, volatility will likely stay low.
But when volatility picks up, many institutional investors, including pension plans, who have been selling insurance against rising volatility by writing VIX options and collecting premiums for doing so will likely be hurt.
Taleb in the Black Swan equates such a strategy to picking up nickels in front of a steamroller.