Editor’s Note: In the April 21 issue of Everybody’s Wrong, I referred to MSTR “trading at all-time highs.”
A more thorough description is that MSTR is trading above the prior-cycle highs and is still in new all-time high territory.
This is a case, like 99% of the arguments on Twitter, that would end immediately if both parties admitted they were talking about different time frames.
Thank you to those of you who wrote in to note the inconsistency. And we’ll be sure to identify our time frames going forward. – JC
Everybody talks about the VIX – you know, the “fear gauge” – when markets get excited.
And just about everybody gets it wrong.
The Cboe Volatility Index measures the annualized implied volatility of S&P 500 options looking out 30 days.
We can also measure the implied volatility for individual stocks.
I’ll be the first to tell you the math behind these measurements is incredibly complex.
Growing up, I was pretty good at math. And I’ve been a professional following markets for more than 20 years.
I promise you, there is no way I would ever even attempt to explain the math behind the VIX or the implied volatility of any security.
This is work for astrophysicists. And even they would have a hard time with it.
But you know me: I like to simplify things. And I’ve simplified volatility for you.
So here are two things you need to know about the VIX…
Know Your Magnitude
If you divide the VIX by 16, that gives you a close approximation of the magnitude of daily market swings.
The VIX closed at a relatively high 33.82 on Monday.
So we can expect at least a 2% move – 33.82 divided by 16 – in the S&P 500 each day it stays in this neighborhood.
A VIX near 50 is pricing in over a 3% daily move. During slower times, with the VIX at 12, let’s say, the market is pricing in less than a 1% move for the S&P 500.
I like to bring this up when the VIX spikes. I like to remind everyone what this actually means to the market, in terms of how it will move.
More important than that, I like to remind us of what we even need to know about it.
Another thing worth noting is the mean-revertingnature of volatility.
It’s the opposite of how asset prices behave.
There’s a lot we don’t know about the market. In fact, I would argue that it’s impossible to know most things, especially about the future.
So we start with what we do know. And we know asset prices trend. We have the data going back a hundred-plus years.
The white papers are published, facts are facts: Asset prices trend.
A stock going up in price has a much higher likelihood to continue to move in that direction rather than completely reverse course and start to fall.
We also know volatility mean-reverts.
High volatility does not stay high – it reverts lower. And low volatility doesn’t stay low – it tends to increase from low levels.
Know Your Move
We can make two general rules about volatility.
We want to be sellers of high volatility.
And we want to be buyers of low volatility.
In the options market, if volatility is high, we want to be net sellers of those options.
This is an opportunity for us to generate more income. We can also finance the purchase of options by selling other options contracts.
When implied volatility is low, we want to be net buyers of options.
To be clear, I’m referring specifically to the implied volatility of the underlying asset.
So, for example, while the VIX may be high, there are still many assets and vehicles where implied volatility is actually relatively low.
And, in low volatility environments, there are always areas where volatility is high and premiums are expensive.
We want to make our decisions based on the underlying asset while keeping the broader market volatility in context.
From an execution standpoint, we’re likely going to be net sellers of options in this environment.
At the very least, we’re going to try to finance our options trades by selling something else.
We’ll be talking more about these strategies in the coming weeks…
Stay sharp,
JC Parets, CMT
Founder, TrendLabs