The Market Doesn't Expect Volatility to Remain Low for Very Long
U.S. stocks are hitting record highs and volatility is hitting new lows, but can it last?
According to Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors, traders should look at more than just the CBOE Volatility Index to get the full picture.
"At sub-12, the VIX seems low considering the macro risks on the horizon. However, looking at just the VIX can be misleading," he writes. "The VIX only measures the cost of options expiring over the next month."
The problem with just looking at the near term, he says, is that this only includes the market's short term expectations. "To gauge how much the market is pricing in risk 'on the horizon', we need to look at longer-dated volatility."
This is where the VIX futures curve comes into play, or what traders expect volatility to be in the longer term future. While it is sitting about where it was one year ago, the curve is steeper, meaning that volatility is expected to increase at a more rapid pace.
In terms of what this means for stocks, Bespoke Investment Group says that there is reason to believe that stocks will see a pullback, but it shouldn't last long.
"There is some validity to the call that we're due for weakness when the VIX closes below 12, but only in the very near term," the firm writes. Its analysis shows that over the next week, the S&P 500 declined an average of 0.56 percent, but then rose 3.04 percent over the next 3 months.
Not only that, but the VIX sitting below 12 isn't actually that unusual. While volatility has been historically high since the financial crisis, there have been a number of periods in the past where it stayed low for quite some time.
But with a lot of unknowns in the market, such as geopolitics to monetary policy, there is certainly a lot of risk to try to price in. Now it all depends on how much of that risk actually comes to fruition.
"If these risks fail to materialize and the market continues to experience low volatility, then the VIX spot will stay low and eventually these VIX futures will 'roll down' the curve to the level of VIX spot, which they must converge with on settlement," Chintawongvanich concludes.