Against the Crowd

Note: The trade detailed in this write up is not suited for all investors and should not be taken as investment advice. It is for informational purposes only. Investors need to do their own investment research before making decisions or consult with a financial advisor before trading derivatives.

When I first started my venture into volatility trading, the United States was in a record low equity volatility environment. The Federal Reserve was keeping their balance sheet steady on the back of a heavy quantitative easing experiment during the prior decade. The largest anxiety blip the market saw that year was due to media hype over a “certain” pending conflict between North Korea and the newly elected President of the United States, Donald Trump.

The VIX index during 2017 reached single digits and never got above 25. It was a year of insanely low volatility that got more depressed as the year went on.

Chart 1: VIX Index From 2014-2023 (Source: Koyfin)

I was young in my trading career, but I knew even from the onset that volatility depressed for long periods of time eventually begets high volatility events. This reasoning is counterintuitive and is seen all throughout nature and human kind. I will give you two quick examples:

1) A forest grows uninterrupted for decades allowing not only the major trees to grow, but also the small plants and weeds to sprout up to cover the forest floor. Animals begin to build their homes in the forest and life continues to prosper in the forest without any reservations. When a small fire starts at the edge of the forest, it begins to spread rapidly as there has not been turbulence in the forest for decades. Wildlife and plants get removed, and the forest starts again from the beginning.

2) A city is built right at the base of a mountain. This city is near the coastline and has mild weather making it a perfect destination. The wealthy citizens in the area flock to this city. The city grows and prospers without friction as the climate is relaxing, and there is little need for worry. That is until the mountain the city is based at erupts and wipes out the inhabitants of Pompeii.

You may be thinking, what do the two scenarios above have to do with markets? Going back to 2017, the market was so “stable” that investors began to sell volatility to increase yield as there were stretches of months without an incident. Moving farther back, it had been over a year since the market saw an event that brought the VIX to levels past 30. This artificial calm in the market gave inhabitants (investors) the false perception that volatility was dead. Nassim Taleb wrote about this concept in his thought provoking book, Antifragile, where he explains living life in a way that does not expose you to challenges, hardships, and uneven terrain sets you up for a major catastrophe when you are not prepared to weather a negative event. Low volatility leads to a fragile life. A forest that goes uninterrupted for decades is more susceptible to a fire that wipes it out completely. A city based at the bottom of a volcano in Mediterranean weather is susceptible to being completely wiped out if inhabitants are not aware of the potential risks and are unprepared to manage them.

So how did the lowest volatility year on record in the market end? The first quarter of 2018 was marked by “Volmageddon”, which wiped out multiple asset managers that were short volatility to pick up additional yield. The VIX did not even spike to record levels to induce this event that caused catastrophe for market participants. The low volatility the year before left asset managers in a fragile state. Additionally, the market saw consecutive years of volatility events after 2017 with the most severe being in unison with the 40% decline in U.S. markets during the COVID-19 outbreak in Spring 2020.

2017 Versus 2023

After making it one quarter of the way through 2023, the market finds itself at a multi-year low point for volatility. The VIX touched 15 and has stayed range bound under 20 for most of the year. That is of course outside of the mini bank crisis in March. The low volatility of 2023 seems odd when the signs are pointing to fragility in the economy. For reference, let’s compare 2023 to the most recent low volatility regime to get a gauge on what lies under the surface.

In 2017, there were several differences in the U.S. economy that impacted the way the market performed compared to today. Quantitative Easing (QE) was still in place by the Federal Reserve, which provided a volatility suppressant across markets. There was negligible geopolitical conflict, which caused little concern for market participants as well. Inflation rates were running at average levels of 2% annually, and interest rates were low and stable. Finally, corporate earnings grew 16% that year. All of these factors drove volatility to historic lows and allowed financial markets to coast up over 18% for the year.

Compare this to 2023 so far. Inflation is over double the Federal Reserve’s 2% target even as it slowly declines from the 2022 peak. The Federal Reserve is embarking on Quantitative Tightening (reverse QE), which should be reversing the volatility suppression of previous years. Interest rate volatility is elevated with the MOVE index over 120 (in 2017 the MOVE index was in the 50’s). Finally, corporate earnings growth is expected to be slightly positive on the optimistic end with some forecasters predicting negative growth this year. Looking at the differences in 2017 versus today, there are major issues with assuming the market is going back to a low volatility regime like 2017.

Table 1: Key Financial Data Points From 2017 and 2023 (Source: Investing.com, multpl.com, Koyfin)

Taking into account the above table, the S&P 500 seems overvalued at a CAPE ratio of 29.4 for the current financial conditions. Market participants are leaning strongly towards a soft landing, which sets the market in a complacent mindset. Complacency coincides with low volatility. Low volatility leads to fragility. Fragility precedes high volatility. Market cycles repeat because human behavior repeats. The last time the VIX was this low was when the “Everything Bubble” peaked in late 2021, and the time before that was in 2020 right before the VIX made its move to the mid 80’s.

Now consider that only a month ago the market was concerned about systemic failures as multiple banks went under in the U.S. and Europe. Did the market’s Mount Vesuvius start smoking without any further action from market inhabitants?

Trading Volatility

As with many investment themes, there are multiple ways to trade the market to gain exposure to the theme. Volatility trading is no different. However, there are some risks with this investment theme that are not common across markets. First and foremost, this investment theme is not for everyone. I would say it is not for the majority of the population. The VIX could go to zero or single digits again (oil went negative in 2020) and provide a large loss to long volatility traders. Nevertheless, the trade I am going to detail is worth noting.

The VIX is an index measuring the expected volatility of the S&P 500 over the next 30 days. Investors are unable to directly invest in the VIX index, so they must use derivative products (example: futures, options, or ETFs). From my experience, VIX related ETFs are not ideal ways to trade volatility, so let’s rule these out for now. Most investors do not have the appropriate knowledge or access to futures, so let’s rule these out for now too. This leaves VIX options in this simple overview. VIX options are not perfect, but they provide access for investors to volatility trading for a low premium.

There are two simple ways to gain long exposure to the VIX index through VIX options:

1) Buy a call option on the VIX index. The problem with this strategy is VIX options are European style and the VIX options you are buying are based on a forward VIX measurement, not the spot VIX. The VIX may have a major move today, but the future dated VIX may not move as aggressively as the spot VIX, causing a shortfall in potential profits. Additionally, VIX call options have theta decay, which slowly erodes the value of the option if volatility does not pick up in the market. Both of these reasons make VIX call options challenging in an environment where the VIX is slowly declining.

2) Sell cash secured put options on the VIX index. This method for gaining long exposure has much less upside, but I would argue has a better probability of a payout. When the VIX index falls below 20, volatility in the market is getting very compressed. There are times when the VIX can stay below 20 for months, but it is not common, especially in economic environments that are uncertain. Buying a put option on an asset bets that the asset price will go lower. Selling a put does the opposite, and you collect the cash from the transaction upfront. If the VIX index is at 19 and you sell a VIX put option a month out at a strike of 18, you collect the premium from the option you sold and you have a break even price lower than the 18 strike for the VIX:

Theoretical Example:

Put Option Premium Received: $1.25 x 100 = $125 (100 is the multiplier)

Put Option Strike Price: 18

Breakeven Analysis: Strike of 18 - Premium Received of $1.25 = Breakeven of 16.75 (not including trading costs)

Max Profit: $125 per contract

Max Loss: $1675 if the VIX goes to zero on expiration if cash secured. I would highly recommend hedging this out with a put spread though as VIX put options under 16 are very affordable. Paying for a put option with a strike price of 14 for the VIX costs roughly $2 per contract ($0.02x100) and eliminates a black swan event from your trade.

Sure, the spot VIX may be below 18 today, but the VIX put options are European style. This means you have no risk of being assigned any asset before expiration (even though these are cash settled options) and the spot VIX is different from the VIX price in the future that the options are currently based on. Therefore, you sell the VIX put with the goal at expiration the VIX is above your breakeven price. Additionally, you get the benefit of the theta decay adding to your profits if nothing happens.

Conclusion

Financial markets never move in a linear fashion. One look at Chart 1 above can show how non-linear moves in the VIX index are. Even though the VIX is suppressed to levels last seen when Quantitative Easing was in place, the market can stay irrational for longer periods of time than anyone expects. To invest accordingly, I believe selling Put options (put spread) on the VIX for June expiration under a strike of 19 has a high probability of success. Even if the VIX does not move past 25 in a risk off event, the option seller gets paid as long as the VIX index ends up above the breakeven.

With the start of May arriving, this begins to be the month of the traditional “sell in May and go away” for markets. The S&P 500 is up 8% through May 1st due to a handful of stocks propping up the index and suppressing volatility. Of all years, 2023 seems to be the most likely for active market participants to sell and wait, locking in early gains for the year and to see how the recession concerns play out later this summer/fall. This would cause downward pressure on the market and increased volatility along with the rest of the uncertainty mentioned above. This mixed with deteriorating economic conditions could prove timely for volatility traders.

Don’t fight convexity.

Disclosures: Portfolios I control are long volatility related investments.

This post consists of high level commentary on research conducted by Tetelestai Capital, LLC into economic conditions and the VIX Index. Though compelling, your own research should always be done before investing into any security. The risks mentioned in this post are not all encompassing either. This post should not be viewed as investment advice. Tetelestai Capital is not associated with any of the investment companies or products mentioned in this post. If you have any questions about the research Tetelestai Capital conducts, please reach out through the website for more information.