Bumpy road ahead

“Buy When There’s Blood in the Streets” – Baron Rothschild

… and sell when everything seems to be alright. The serenity of the markets might be unsettling for contrarian-investors. The VIX (implied volatility index) is reportedly cheap, hitting multiyear lows, indicating that market players – or at least those who have access to these hedging instruments – expect no correction in the short term, as the index trails only 30 days. However, the concerns are below the surface, hidden in least known indices and instruments.

First a quick catch up for those who are not entirely familiar with option trading and the importance of volatility. Among other metrics and constant, option pricing requires 3 main inputs: the timeframe the option can be called, the risk-free interest rate for discounting purposes, and the expected volatility. However, in the real world the last bit is rather an output, a side-product of trading, rather than an ingredient.

What is the option for? As a hedging instrument option can be perceived as insurance policies. I pay a premium, and if the non-desirable outcome materialized I can make a claim on the multiple of the paid price. The more likely the outcome the more encouraged option buyers will become, while suppliers (insurers) might want to re-evaluate the likeliness of claims and increase their premiums. Both trend points towards higher prices.

Risk-free rates and timespans are known, not changed by the option market`s sentiment. Prices, on the other hand, might very well be a victim of changing attitudes. In order to equilibrate the option pricing formula, the only variable which `must have changed` is perceived volatility in the lifetime of insurance policies. Thus, the implied volatility index has been born by using the above derivation.

VIX measures all the options which are currently out-of-money (the strike price has not been reached yet or the trigger event is still ahead with other words). If it were health insurance it would cover minor injuries just as life threatening ones, a whole bundle of outcomes. The SKEW index (also published by the Chicago Board Options Exchange (CBOE)) rather resembles a life insurance. The calculation merely relies on outstanding options which have a strike price 2-3 standard deviations out-of-money, meaning they are highly unlikely and would be fatal for the underlying market.

Currently the big fish trading such indices kept the general insurance cheap, while the life-insurance policies have been slowly crawling higher as the bull-market matures. Why bother to pay for papercut coverage when we are heading towards the edge of the cliff? At least the narrative of markets suggests it… my takeaway point is only that one should always examine the whole scope of sources, and don’t get deceived by a single metric. The current sentiment is far from calmness, which is also reflected in record amounts of dry gunpowder to support the market a bit longer, or for more prudent fund managers to be used to buy the dip in case of a collapse.

vixskew

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