April 3, 2017, 4:00pm EST Invest Alongside Billionaires For $297/Qtr
As we discussed last week, we should expect more volatility in markets in the coming months, with the continued discovery surrounding Trump Policies (timing, size) and with UK/EU Brexit negotiations officially opening. That’s a dose of unknowns which should send stocks swinging around quite a bit more than we’ve seen for the past four months.
Remember, on Friday I noted the message the bond market was sending — with market interest rates (U.S. 10 year yields) closing the week, and quarter, at 2.39%. That’s almost a quarter point lower than the high that followed the March rate hike (the third in the Fed’s “normalization” process). And it’s about 10 basis point lower than where the 10 year stood going into the December 2015 rate hike. That’s a negative signal. And I suspect stocks will get that message.
With that said, the first day of the second quarter opened today with a slide in stocks, a slide further in yields and a rise in the price of gold.
When stocks go down, people get nervous and buy downside protection. That tends to spike implied volatility. There’s an index that measures that called the VIX.
Let’s talk about the VIX…
The VIX measures the implied volatility of options on the S&P 500. This is a key component in the price investors pay for downside protection on their portfolios.
So what is implied volatility? Implied volatility measures both actual volatilityand the options market maker community’s expectations (or perception of certainty) about future volatility. When market makers feel confident about the stability in markets, implied vol is lower, which makes the price of options cheaper. When they aren’t confident in stability, implied vol goes up, which makes the price of an option go up. To compensate those that are taking the other side of your trade, for the lack of predictability, you pay a premium.
You can see in the chart below, vol is very, very low — but has been ticking up.
Still, it takes a significant event – a high dose of uncertainty – to create a spike in implied volatility.
That spike tends to correlate well with a sharp slide in stocks. Otherwise, we’re looking at a garden-variety correction in stocks — and that’s what this low vol environment is spelling out.