Beware the low-volatility trap

The current bull market has broken many records this past year, not the least of which is the length of time volatility has wallowed at extremely low levels. But at some point—no one knows when—volatility will return to the US equity market.

The CBOE Volatility Index (VIX)—the so-called “fear gauge” derived from the implied volatility of S&P 500 options—has been closing out the year near its historical lows, miles away from fear. And here’s a volatility fun fact for you: The VIX has had more than 200 days this year with a closing price in the bottom 10% of all closing prices of the previous 10 years. The last year to come even close to that number was 2006.

Stock traders who have been using approaches that assume low-volatility conditions will persist indefinitely (e.g., shorting VIX futures, selling option premium, or simply increasing long position size) need to be prepared for a changing of the market guard—or risk getting crushed when volatility doesn’t immediately retreat after its next upward spike.

Take a look at the chart below of the CBOE Volatility Index (VIX) over the past dozen or so years. It wouldn’t be necessary for the VIX to return to 2008 levels to hurt a lot of short-volatility traders—a spike similar the ones that occurred in 2010, 2011, or 2015 would do the trick.

Volatility Index (VIX), 4/18/2005 – 12/19/17

Source: OptionsHouse

So what to do? The longer the bull market goes without a significant correction, the closer it is to such an event—and a corresponding volatility spike. No one likes to give up profits in a bull market, but traders who find they might be banking too much on low-volatility conditions can consider reducing trade size, hedging positions with long options (i.e., getting long some volatility), and/or looking for short-side opportunities.


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