Why I’m not surprised to see such a volatility expansion

On November 15, 2019, I published “Periods of low volatility are often followed by volatility expansions” and included the below chart.

The point is just as the title said, when stock prices trend up quietly, they are eventually interrupted by the loud bang of falling prices.

Average True Range ATR use in portfolio management trading volatlity

In this case, it took a few months to see it play out.

Below, I updated the chart so it still has the same starting date, but shows us what happened after I posted it. The 11/15/19 day is labeled on the chart. It had a small decline shortly after, but then resumed the uptrend.

2020 stock market crash volatility expansion

In fact, the stock index went on to gain 9% from that point and was interrupted by only two small countertrend declines of 3-4%.

That is, until February 19th.

Since the peak, the stock index has declined -19% and volatility has exploded.

The volatility measure I used in the chart is an average of the true range, which accounts for a full price range of the period. The average true range is also what I used to draw the channels above and below the price trend to define “normal” price action.

The average true range of the price trend has increased by 420% since December, from 17 to 97. I know it shocked most people in the market and while I didn’t expect a -19% waterfall in just three weeks, I expected a volatility expansion and mean reversion. As I exited stocks a little early, we see now it didn’t matter this time as the stock market has given up far more upside than we missed out on over those few weeks.

Next, let’s look at a chart of implied volatility as indicated by the VIX based on how the market is pricing options. Implied vol spiked over 200%. I also included the 30-Day rolling volatility of the S&P 500 ETF. Implied volatility lead realized, historical, volatility to the upside.

volatilty expansion vix realized

So, the condition of the US stock market is volatile one as prices and swinging up and down, and only December 2008 in the middle of the Financial Crisis was it higher.

vix volatility trading asymmetric risk reward

If the VIX is a fear gauge, it’s signaling a lot of fear.

Again, “Periods of low volatility are often followed by volatility expansions” and that’s what we got. This time it got stretched on the upside so far it has snapped back to very quickly and violently correct it.

The good news is, the opposite is also true; periods of high volaltity are eventually followed by volatility contractions.

But, just as before, as it took time for the volatility contraction to become a volatility expansion, we’ll probably see a continuation of price swings and elevated volatility for a while.

Eventually, this too shall pass.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas. Shell Capital is focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. I observe the charts and graphs to visually see what is going on with price trends and volatility, it is not intended to be used in making any determination as to when to buy or sell any security, or which security to buy or sell. Instead, these are observations of the data as a visual representation of what is going on with the trend and its volatility for situational awareness. I do not necessarily make any buy or sell decisions based on it. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

Expect wider price swings in a volatility expansion

I know, it sounds obvious, but yeah, expect wider price swings in a volatility expansion.

The CBOE S&P 500 Volatility Index (VIX) is a popular measure of the stock market’s expectation of volatility based on S&P 500 index options. The VIX Index is a calculation designed to produce a measure of a constant, 30-day expected volatility of the US stock market, derived from real-time, mid-quote prices of the S&P 500® Index (SPXSM) call and put options.

The VIX index shows us the 30-day expected volatility increased 200% during the February 2020 volatility expansion. I may have to define this rate of change as a volatility explosion. Expansion is the act or process of expanding to become or make larger or more extensive. An explosion is a rapid increase in volume and release of energy in an extreme manner. This looks explosive.

February 2020 stock market decline volatility exansion

Viewing it over a wide range of the past 10 years, the 30-day expected volatility is elevated to the second-highest level seen since the 2007-09 stock market crash. In 2011, the VIX spiked to 48.

VIX 1 year volatility expansion trading asymmetric

Putting it into an even broader perspective with the larger sample size of 26 years of historical data, the recent 40 level is about as elevated as 30-day expected volatility gets.

30-day expected volatility

I observe volatility from a perspective of both implied (expected) volatility and historical (realized) volatility. Implied volatility a measured by the VIX Index, is typically priced at a premium since options trading sentiment tends to have more of a hedging tilt. In theory, the VIX at 40 suggested expected 30-day volatility of 40%, which is much higher than the 21.5% realized vol as measured by 30-day Rolling Volatility derived from the actual past 30 days of price action. This is just an idealized, overly simplified example, but the point is both realized and expected vol is elevated.

implied vs realized volatility

Asymmetric volatility is what we see when equities fall sharply. The asymmetric volatility phenomenon is the observed tendency of equity market volatility to be higher in declining markets than in rising markets. Volatility tends to decrease after prices have trended up as investors and traders (the market) become more and more complacent, expecting a smooth uptrend will continue. Then, after prices decline, complacent investors and traders are caught off guard and surprised when prices trend down, and the more prices fall, the more they fear losing more money. The fear of losing money, then, is another driver of asymmetric volatility; Investors experience the pain of loss twice as much as the joy of gains. Nobel Prize-winning behavioral research finds that losses loom larger than gains and that people are loss averse. So, after prices have fallen, investors and traders sell simply because prices are falling, to cut their losses, and avoid larger losses. This selling pressure becomes a serial correlation, contagion, and prices keep falling until the desire to sell has dried up. It’s what I believe, at least, after studying and observing price trends in real-time professionally over two decades.

We saw asymmetric volatility expansion after the astonishingly smooth uptrend in 2017. In the chart, I overlay the 30 Day Rolling Volatility to visualize how the realized vol declined as the S&P 500 trended up quietly. But lower and falling volatility periods tend to be followed by periods of rising volatility.

asymmetric volatility trading exansion hedge hedging

US equities went on to recover two major price shocks and asymmetric volatility expansions in 2018, but here we are in 2020 seeing another smooth uptrend with great momentum interrupted by volatility expansion driven by a waterfall decline in stocks. 

Februrary stock market volatilty what caused crash

Asymmetric volatility is when prices drift (trend) up and then crash down.

When realized and implied volatility is elevated, we should expect to see price swings both up and down. Recovery from a downtrend like this is a process, not an event. We’ll probably see many swings up and down along the way, which is especially true if this unfolds into a bigger bear market level downtrend. Although anything can happen, bear markets don’t just happen all at once. The worst bear markets like 2007 to 2009 unfolded with price swings over many years, not just in 2008.

Only time will tell if this is the early stage of a bigger move, but in the meantime, expect larger price swings as prices spread out and the weight of investors decide which direction to lean.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas. Shell Capital is focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. I observe the charts and graphs to visually see what is going on with price trends and volatility, it is not intended to be used in making any determination as to when to buy or sell any security, or which security to buy or sell. Instead, these are observations of the data as a visual representation of what is going on with the trend and its volatility for situational awareness. I do not necessarily make any buy or sell decisions based on it. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

What volatility expansions tell us about expectations for stock market trends

A volatility expansion implies that stock prices are expected to spread out more, as measured by the (VIX) CBOE Volatility Index. Currently, it’s at 28, which would imply a 28% expected volatility over the next 30 days, except it tends to be priced at a premium above realized vol.

vix volatility expansion asymmetric hedge options

Then, historical volatility, or realized actual volatility,  such as the 30-day rolling volatility, suggests prices are indeed spreading out. So, expect a wider range up AND down in volatility expansions. In the chart below, 30 Day Rolling Volatility = Standard Deviation of the last 30 percentage changes in Total Return Price * Square-root of 252. At this point, it’s at 17.71% when applied to the S&P 500 stock index data.

asymmetric volatility trading hedge

Here they are together, expected volatility on top of realized volatility.

vol expansion

A volatility expansion like this suggests in the near term stock prices are expected to spread out more, but up and down.

We are seeing a broad range of prices today, form up 1.4% to down -0.60%, as seen below.

SPY SPX TRADING

So, if you are invested in the stock market, prepare yourself accordingly. Need help? Contact us here.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. I observe the charts and graphs to visually see what is going on with price trends and volatility, it is not intended to be used in making any determination as to when to buy or sell any security, or which security to buy or sell. Instead, these are observations of the data as a visual representation of what is going on with the trend and its volatility for situational awareness. I do not necessarily make any buy or sell decisions based on it. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

19 is the new 20, but is this a new low volatility regime?

We used to say the long term average for the Cboe Volatility Index VIX is 20.

Some would mistakenly say that VIX “reverts to the mean”, suggesting it is drawn to the average level of 20, which isn’t exactly the condition. It doesn’t cycle up and down to trend around 20 most of the time, but instead, it spends much of the time between 10 and 30.

Prior to 2015, the long term average of VIX since its inception was 20 and we heard the number 20 referenced with VIX often. ^VIX Chart

Since January 2015, we’ve seen the long term average decline to the 19 levels.  ^VIX Chart

So, 19 is the new 20.

What caused the downtrend in the long term average?

Obviously, it would take a very low level of readings to drive down the long term average of a volatility index introduced in 1993.

What happened in the past 5 years that impacted the prior 21 years of data so much to bring the 26-year average down?

A 5 year period of low implied volatility happened with an average of 15% and a low of 9.14%. Said another way; the past 5 years expected volatility priced into S&P 500 stock options has been about 25% lower than the prior two decades, or 75% of what we previously observed. Here is the trend for VIX from 2015 to today. A VIX level of 15 translates to implied volatility of 15% on the S&P 500. 
^VIX Chart

Is this a new low volatility regime?

Anything is possible, but I’m guessing the lower level of implied (expected) volatility may be driven by two facts that can both result in less concern for volatility.

  1. The current bull market that started in March 2009 is the longest bull market in history. It exceeded the bull market of the 1990s that lasted 113 months in terms of time, though still not as much gain as the 90s.
  2. The U.S. is in its longest economic expansion in history, breaking the record of 120 months of economic growth from March 1991 to March 2001, according to the National Bureau of Economic Research. However, this record-setting run observed GDP growth far slower than previous expansions.

The aged bull market and economic expansion can naturally lead to some level of complacency and expectation for less downside and tighter price trends. When investors are uncertain, their indecision shows up in a wide range of prices. When investors are smugger and confident, they are less indecisive and it’s usually after a smooth uptrend they expect to continue.

Is it another regime of irrational exuberance?

“Irrational exuberance” was the expression used by the former Federal Reserve Board chairman, Alan Greenspan, in a speech given during the dot-com bubble of the 1990s. The expression was interpreted as a warning that the stock market may have been overvalued. It was.

Irrational exuberance suggests investor enthusiasm drives asset prices up to levels that aren’t supported by fundamental financial conditions. The 90s ended with a Shiller PE Ratio over 40, far more than any other time in more than a century.

Is the stock market at a level of irrational exuberance?

Maybe so, as this is the second-highest valuation in the past 150 years according to the Shiller PE.

shiller pe ratio are stocks overvalued

But, the driver here is inflation. When inflation rates are really low, we can justify a higher price to earnings ratio for stocks, so they say.

A new VIX average level of 19 translates to the implied volatility of 19% on the S&P 500 instead of the former after of 20%. It isn’t a huge range difference.

Looking over the full 26 years of implied volaltity, the more elevated levels in the past included the late 90s into around 2003, which elevated the average. Since then, we’ve seen more spikes up but not as many volatility expansions that stay high for longer periods. ^VIX Chart

A behavior of implied volatility I’ve observed over time is it spikes up very fast when the stock market drops and then trends back down more gradually as stocks trend back up.  For this reason, derivatives of volatility provide us an opportunity for asymmetric hedging.

I doubt this is a new lower long term volatility regime. My guess is we’ll see a very significant volatility expansion again at some point during the next bear market and economic recession. Historically we’ve observed trends that stretch far and wide swing back the other way, far and wide.

At a minimum, it’s no time for complacency.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

 

Volatility is trying to settle down

The Cboe Volatility Index VIX is back to its average of 15 over the past year, which implies volatility of 15% for the S%P 500 for the next 30 days based on options prices.

Indexes like the VIX may have no predictive ability as to market direction at this level, but options don’t lie. The options market is a two-sided market and two-sided markets provide some insight. Options can have predictive power at extremes, but in most cases, the speed is to the downside.

The Cboe VVIXSM Index is the volatility of VIX. The VVIX Index is an indicator of the expected volatility of the 30-day forward price of the VIX. This volatility drives nearby VIX option prices. Like the VIX, it’s also at its average level of the past year. ^CBVVIX Chart

My next observation is the Cboe 3-Month Volatility Index (VIX3M).  Once again,  at its average. S&P 500 3-Month VIX Chart

Next is the VIX Futures Term Structure. VIX futures reflect the market’s estimate of the value of the VIX Index on various expiration dates in the future. Monthly and weekly expirations are available and trade nearly 24 hours a day, five days a week. VIX futures provide market participants with a variety of opportunities to implement their view using volatility trading strategies, including risk management, alpha generation and portfolio diversification. All of these volatility trading strategies are reflected in the futures prices and the term structure shows it.

VIX Term Structure

The upward-sloping VIX futures term structure is called contango and the current contango between the front month and next is 2.5%, which is small.

The upward-sloping VIX futures term structure as we see now suggests that short-term volatility is relatively low compared to its long-term level and investors/traders expect an increase in volatility in the future.

So, as the stock market is trying to regain its prior highs, volatile is trying to settle down for now. We’ll see if it can hold.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

 

Here comes the volatility expansion, but is the coronavirus outbreak in China to blame?

The Dow Jones Industrial Average is down 460 points and headlines mostly blame the coronavirus outbreak in China as it spreads around the world.

A few headlines this morning:

Stocks Tumble Around the World on Virus Jitters

China Deaths Jump as Measures Fail to Slow Spread of Virus

What’s Being Done to Limit the Spread of the China Virus

Millions Left Worried, Angry and Isolated After Wuhan Lockdown

Stocks Drop on Coronavirus Fears

The Dow industrials fell about 400 points as detection of coronavirus in new patients in the U.S., Australia and France led to escalating concerns about the containment and potential economic impact.

People love a good story, so the narrative gets the blame for falling prices.

As I shared in What’s the stock market going to do next? and Periods of low volatility are often followed by volatility expansions, it’s really just the market, doing what it does.

The stock market is declining simply because it was priced for perfection. You can see in the chart below, as the price trend of the S&P 500 stock index trended up the past several months, its volatility, or the range of prices, was tight.

Who doesn’t love a quiet uptrend?

It was a nice quiet uptrend, suggesting investors were complacently enjoying the ride. I was to until it reached an extreme, then I hedged off some risk, then reduced the possibility of loss completely by taking profits and shifting to short term U.S. Treasuries.

This time, I was just a little early with my hedging, but that was ok. The higher stocks trended up and more volaltity contracted, the more likely the trend would reverse down and volatility expands.

That’s what we’re seeing now.

volatlity expansion spx spy dia vix

While an SPX at 3200 is a ‘normal’ range for the market to move, I wouldn’t be surprised to see the price trend decline to the blue line I marked on the chart.

Of course, as I said in Now, THIS is what a stock market top looks like!, it could be an even larger peak, too.

Anything is possible, which is why we necessarily need to actively direct and control the possibility of loss for asymmetric risk-reward.

I don’t believe this price decline is driven by the coronavirus outbreak in China as it spreads around the world. I think it’s just the market, doing what it does, as I’ve shared the past several weeks. Some catalyst gets the blame for it.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

How low can implied volatility VIX go?

Volatility measures the frequency and magnitude of changes, both up and down, that we experience over a certain period of time.

When we speak of volatility in the financial markets, we necessarily mean the magnitude of price movements, both up and down, over time.

So, volatility is how quickly and how far a price trend spreads out.

The more dramatic the price swings, the higher the level of volatility.

Volatility can be measured using actual historical price changes (realized volatility) or it can be a measure of expected future volatility that is implied by option prices.

The VIX Index is a measure of expected future volatility.

The VIX index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX) call and put options.

When the VIX is low, a lower level of volaltity is implied, or priced in, to the options. When the VIX is high, expected volaltity is high.

Recently, the implied volatility index VIX has been very low at times. As seen below, I added the low of the past year to the chart, which was 11.54, which is lower than today.

VIX record low volatility expansion contraction

But, the long term average VIX level is 19 and the lowest level the VIX has reached since its inception was 9.14 reached late 2018.

VIX long term average low and high level

To put the 9.14 level into perspective, here is the past three years and how low the VIX was in 2018 as complacency set in.

VIX lowest level 2018

Can stocks keep trending up and implied volatility drift lower?

Absolutely.

But, what happened after it did?

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

 

Volatility is expanding, a little

To no surprise, the CBOE S&P 500 Volatility Index that represents the market’s expectation of 30-day forward-looking volatility, is trending up. 

VIX VOLATILITY EXPANSION ASYMMETRIC RETURNS

So far, it isn’t much of a volatility expansion, but it’s elevated somewhat higher than it was. At around 15, the VIX is also well below its long term average of 18.23, although it hasn’t historically been drawn to the 18-20 level, anyway. The average is skewed by the spikes in volatility; volatility expansion. 

VIX is at a current level of 14.82, an increase of 0.80 or 5.71%% from the previous market day.

Here are the 50 and 200-day moving average values for VIX.

VIX MOVING AVERAGE

As I shared over the weekend, and it was quoted in today’s MarketWatch article “U.S.-Iran tensions will spark increased volatility — here’s how to play stocks, fund manager says“:

“So, on a short-term basis, the stock indexes have had a nice uptrend since October, with low volatility, so we shouldn’t be surprised to see it reverse to a short-term downtrend and a volatility expansion.

“For those who were looking for a ‘catalyst’ to drive a volatility expansion, now they have it.”

I was referring to the U.S. conflict with Iran, of course. 

The VIX index value is derived from the price inputs of the S&P 500 index options, it provides an indication of market risk and investors’ sentiments. VIX measures the implied ‘expected’ volatility of the US stock market. So, many market strategists use the VIX as a gauge for how fearful, uncertain, or how complacent the markets are. The VIX index tends to rise when the market drops and vice versa. During the 2008-2009 bear market, the VIX trended up as high as 80.86. Although the VIX cannot be invested in directly, securities like ETFs and derivatives based on it may provide the potential for an asymmetric hedge. For example, over the past year when the S&P 500 stock index was down -1% or more on the day, some of the ETFs based on long volatility spiked 10% or more. Volatility is difficult to time right, but when we do the payoff can be asymmetric. An asymmetric payoff is achieved when the risk-reward is asymmetric: maybe we risk 1% to achieve a payoff of 5%. Since long volatility has the potential for big spikes when volatility expands, it’s asymmetric payoff doesn’t require the tactical trader and risk manager to be as ‘right’ and accurate. So, the probability of winning can be lower, but the net pay off over time is an asymmetric risk-reward.

You can probably see why I pay attention to volatility and volatility expansions.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

 

How will the conflict with Iran impact global equity markets?

On December 30th someone tweeted the headline:

IRAN WARNS U.S. ITS MIDDLE EAST DOMINANCE IS OVER AFTER NAVAL DRILLS WITH RUSSIA, CHINA

I replied and shared the link to the Newsweek article about the threat from Iran:

According to the NPR timeline of Iran events, it started a few days sooner.

Friday, Dec. 27: Attack near Kirkuk

Militia group Kataib Hezbollah attacks the K1 military base near the Iraqi city of Kirkuk with rockets, killing an American contractor and wounding several American and Iraqi personnel. Kataib Hezbollah has ties to Iran. It has denied orchestrating the attack.

In response:

Sunday, Dec. 29: Trump orders some airstrikes

Tuesday, Dec. 31: Embassy compound stormed

On Tuesday morning, Iraqi supporters of Kataib Hezbollah begin storming the U.S. embassy in Baghdad. The violence escalates, with militia members attempting to enter the embassy, starting fires and damaging the outside and a reception area of the embassy.

The conflict in Iran escalates:

Thursday, Jan. 2: Esper’s warning; Soleimani killed

Esper gives a statement emphasizing that the U.S. “will not accept continued attacks against our personnel & forces in the region.” He also sends a message to U.S. allies to “stand together” against Iran.

U.S. Marines are deployed:

Thousands of Marines Head to Middle East on Navy Ship as Iran Pledges Retaliation

A Navy amphibious assault ship with thousands of Marines on board will skip a planned training exercise in Africa to instead head toward the Middle East as tensions there spike.

Now, infantry from the U.S. Army:

750 soldiers with 82nd Airborne headed for CENTCOM, additional 4,000 troops expected to deploy as Iran tensions mount“At the direction of the Commander in Chief, I have authorized the deployment of an infantry battalion from the Immediate Response Force (IRF) of the 82nd Airborne Division to the U.S. Central Command area of operations in response to recent events in Iraq,” Secretary of Defense Mark Esper said Tuesday evening in a written statement.

Just like that, we go from a relatively peaceful time to what may become another war in the middle east if Iran doesn’t stand down.For some of us, these things hit closer to home when we know those being deployed. But, you don’t sign up to be a U.S. Marine or Army Ranger expecting to get through your tour without deployment and the possibility of combat. As Americans, we are fortunate for our Sheepdogs yearning for a righteous battle: On Sheep, Wolves and Sheepdogs.

How will the conflict with Iran impact U.S. and global equity markets?

I don’t know.

Neither does anyone else.

But I do have an idea, and it’s pretty obvious it isn’t positive news, though we never know for sure how the world markets will react to any news.

Although I am regarded as a “global macro” investment manager, I don’t focus so much on the “macro” as in “macroeconomics” as I do the direction of price trends and their volatility.

Economic indicators, as well as fundamental evaluations, have the potential to be very wrong and stay wrong. If you believe ABC stock is cheap at $50, you really believe it cheap as it falls -50% to $25 and then what if it drops to $5? Not my cup of tea.

That dog don’t hunt.

I focus instead on directional price trends.

The concept is very simple:

  • If I’m long an asset that is trending up, it’s good.
  • If I’m out of assets that are trending down, it’s good.
  • Or, if I’m short assets that are trending down with the potential to earn a profit from the downtrend, it’s good.

It’s easier said than done, so it isn’t so simple to operate. For example, what time frame is a trend? Why one time frame over another? It all has to be quantified to determine what is most robust.

And you know what? that changes, too.

It’s not as simple as running a backtest to determine the best signals, parameters, and time frame to apply them to and then expecting the future will be just like the past. Past performance doesn’t always indicate future results. So, this requires work. It also requires me to keep it real.

I’ve been pointing out for a few weeks that a volatility expansion seems imminent. Since I first observed it, the S&P 500 index had a minor decline of 2-4% before continuing its uptrend. The U.S. equity market has been bullish. But, here we are again. The price trend has drifted above its average true range channel. A price trending above its average true range is positive, but when it stays above it, it can also result in mean reversion. That is, the price may drift back toward the middle of the volatility channel like it did early December.

spx spy ATR volatilty expansion asymmetric

So, on a short term basis, the stock indexes have had a nice uptrend since October with low volatility, so we shouldn’t be surprised to see it reverse to a short term downtrend and a volatility expansion.

For those who were looking for a “catalyst” to drive a volatility expansion, now they have it.

We don’t know what’s going to happen next in Iran, but what I do know is exactly how I’ll respond to changing price trends.

I predetermine my exits in advance to cut losses short.

I predefined my risk and know how much risk exposure I have at any time.

Since I do this for all of my positions, I know how much risk I have accepted in each individual position, but I also know how much portfolio risk I have for drawdown control.

As a simple example, if I had 15 positions across global markets and each of them has their own individual exit points where I would sell to reduce exposure, then I can use the summation of that risk at the portfolio level to predetermine a drawdown limit. Of course, any hedging positions such as a short S&P position, reduce the portfolio risk of the longs, too. And, not all of these global positions are necessarily driven by the same return drivers, so they may not all be correlated. So, they may not all trend up or down together. For example, when the S&P 500 stock index has had a down day of -1% or more the past fifteen years, the Long Term U.S. Treasury has gained an average of 0.80% on the same day. An even more asymmetric example is on the same day the stock index fell -1% or more, the long volatility index-based ETFs may have gained 5% to 15% on the same day.

It’s times like this when my process and systems become more obviously necessary.

For everyone else, there’s buy and hold with no limit to their downside loss.

That dog don’t hunt, for me. 

Let’s hope for peace in the middle east, but if they don’t want peace, Godspeed to our Troops as they enter and embrace the unknowable. 

Semper Fidelis.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

Is the volatility expansion over?

Using the S&P 500 stock index as a proxy for the stock market, today we saw a modest uptick. It’s now back within a normal range. Realized volatility as measured by the average true range of the past 14 days has trended up. Volatility isn’t directional, so a volatility expansion involves but down and up days.

spx trading

Implied volatility of the S&P 500 stocks had a sharp move up and settled back down some today. Applying the same realized volatility measures to the VIX is a view of the realized vol of implied vol. Yesterday may turn out to have been a good time to exit long volatility positions, or maybe it explodes from here.

ViX #VIX $VIX volatility trading asymmetric

The VIX futures term structure closed 10% contango. The December VIX futures are 10% lower priced than January. The curve is flatter beyond February.

vix-futures-term-structu

This contango creates a headwind for VIX ETFs that roll each day as they sell the January futures at a lower price and buy the February at a 10% higher price. It’s why the VIX exchange-traded funds and notes trend dow long term. So, they aren’t suitable for anyone to hold for long.

VIX may stay within the range and the stock market trend back up.

We’ll see.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The use of this website is subject to its terms and conditions.

A volatility expansion seems imminent

On November 16th, about two weeks ago, I shared an observation in “Periods of low volatility are often followed by volatility expansions” that implied and realized volatility had reached such a low level we should expect to see a volatility expansion.

I also pointed out investor sentiment had been reaching excessive optimism. The type of excessive optimism we normally see when less-skilled investors have an urge to buy stocks instead of a hedge or sell them to reduce risk.

It was plenty early, as expected, which is better than being late.

When I share these observations, the intent is to highlight an extreme trend or cycle I expect to shift the other direction. In this case, I saw the range of prices was getting tight, suggesting to me there was little indecision in the market, which also implies confidence and complacency.  I say this, having been monitoring these market dynamics daily and professionally for over two decades.

The chart I included showing the S&P 500 price trend peaking at the upper band of its range and its average true range at what I consider an extreme low go included in MarketWatch, then Barron’s, and then today The Daily Shot in the Wall Street Journal.

Mike Shell Wall Street Journal WSJ

Since that chart is now two weeks old, here’s an update. The S&P 500 has trended down about -1.2% the past two sessions and its price is back inside the volatility bands. However, notice the bands have contracted since October, so I say again: Periods of low volatility are usually followed by volatility expansions.

volatllity expansion vix asymmetric december 2019

So, stay tuned, a volatility expansion with at least a minor price correction seems imminent.

Prepare yourself accordingly.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The use of this website is subject to its terms and conditions.

Periods of low volatility are often followed by volatility expansions

I like uptrends, until the end when they bend.

This uptrend in U.S. stocks hasn’t seemed ready to bend, but we are observing signs a reversal down could be soon. I’m not necessarily talking about a market crash of -50%, but instead a decline of around -5% or so that we typically see a few times a year as we’ve seen twice this year.

The “long term” investors may wonder why it matters?

All big waterfall declines begin with smaller downtrends. Few stay “long term” investors after large declines. After -30% declines or more, most anyone’s financial plans become negatively impacted. It’s especially true since we don’t know how long it will take to recover and there is no guarantee it will.

So, as a tactical risk manager, I necessarily prepare and apply situational awareness. If we want to manage our drawdowns, we want to do it sooner than later. Everyone is always giddy at all-time highs, then regretful if they don’t derisk or hedge after a downtrend.

Below is an example of a measure of realized volatility charted with the stock index. The top line is the 20-day average true range of the S&P 500 (SPX) and the lower is its price trend. I marked it up to show the average true range indicates a volaltity contraction like we’ve seen twice this year. The point is it preceded a volatility expansion and price declines.  I also added the blue bands around the price trend that reflect two times the average true range of the price trend. When the price trend moves outside this volatility band, I consider it simply outside its recently normal range. As you can see, it can stay outside its range for a while, but the price trend mostly oscillates inside this range. When it swings outside the range, it means reverts or swings the other way.

Average True Range ATR use in portfolio management trading volatlity

We can say the same for expected volatility, as measured by the CBOE Volatility Index, which measures implied volatility on the S&P 500 stocks. The VIX has declined to the 12 level, the low level of its historical range.

VIX $VIX #VIX IMPLIED VOLATLITY

Periods of low volatility are often followed by volatility expansions.

The SPX trend can trend higher, and volaltity can drift lower, but in the short run, it’s a good time to check thy risk.

Investment management is all about probabilities and possibilities, so you can probably see the direction is most probable, though anything is possible.

Why does any of this matter? read Why we row, not sail.

For an update, see A volatility expansion seems imminent

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The use of this website is subject to its terms and conditions.

The stock market is in a period of indecision that it will break out of

As I’ve been pointing out all month in August, the stock market is in a period of indecision, that it will eventually break out of.

Looking at the price trend of the S&P 500 index over the past six months, todays 1.4% move so far has the trend tapping the upper end of the range.

asymmetric risk reward return stocks

Zooming in to the beginning of the month of August, it’s been a month of indecision. Those who want to buy are battling with those who want to sell.

The range of the price trend has spread out, as was implied by the CBOE S&P 500 Volatility Index VIX. It’s been a relatively volatile month with this big-cap stock index swinging up and down in a range of 4%.  As we can see in the chart below, the VIX trended up sharply as stocks declined in price.

What we also see, however, is implied is settling back down as the price trend is swinging up and down in this 4% range of indecision.

What’s going to happen next? 

I don’t need to know what’s going to happen next. I know exactly what I’ll do next with my positions if they continue trending up, or reverse back down.

Using this stock index as an example, if it breaks below this range it’s bearish, but if it has the buying demand to break above it, the uptrend resumes.

That’s why we call price action as we’ve seen this month a base patter and we’ll eventually see a big move out of it one direction or the other.

The S&P 500 index is an unmanaged index and cannot be invested into directly, but if we could and I wanted to be long stocks, I would exit if it fell below the three recent lows.

If I wanted to be short, I would exit if it broke out above the prior high.

This is just an oversimplified example of how I tactically manage risk.

Hurricane Dorian looks to add to the August volaltity.  Hurricane Dorian is now expected to intensify into a Category 4 hurricane as it moves toward Florida and the U.S. Let’s hope it loses its momentum. I’m in Tampa Bay on the other side. It should slow down by the time it reaches us. Our home is made of concrete, tile roof, and 150 MPH hurricane windows, so we’ll be fine.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data is deemed reliable, but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

The volatility expansion is here…

Since I mentioned it a week ago, volatility has indeed expanded.

In fact, it’s increased 32% today alone.

Implied volatility as observed by the VIX has almost doubled the level it was a week ago.

The Fear & Greed Index is now at the “Extreme Fear” level. VIX is one of the signals it uses to measure the degree of investor panic.

how to use fear greed index

Clearly, the options market has now priced in more expected movement in the range of prices. When I mentioned it a week ago, it implied a 12% range, now it’s 23%.

The S&P 500 stock index is down 3.35% today.

stock market 2019

We’ll see if this is enough panic selling today to drive prices low enough to attract new buying demand.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data is deemed reliable, but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Measuring the volatility expansion

To no surprise, we are observing a volatility expansion.

I say it isn’t a surprise, because I shared my observation on July 28th in Is volatility setting up for an expansion? the following:

I’m not going to be surprised if we see a VIX volatility expansion this week along with the range of stock prices spreading out.

There are plenty of potential catalysts that could drive volatility and uncertainty higher for those who need a story driving it.

This morning, the CBOE Volatility Index® (VIX® Index®) is trending 20% to 21.20, which is its long term historical average. As I pointed out before, it was at 12 when I pointed out the possibility of a volatility expansion. I didn’t expect to see it just because it was at a low level of 12, but instead because there was no shortage of potential catalyst that could cause prices to spread out into a wide range from indecision.

The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, theVIX®Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.

The VIX has gained 76% since I shared the observation.

Is there a way to trade this volatility? Yes, there is, and it’s easier said than done. Tactical traders can trade VIX options, futures, ETFs, or the ETN. I share the below chart for informational purposes only. It’s the iPath® Series B S&P 500® VIX Short-Term FuturesTMETN charted along with the VIX index and does not necessarily represent any position I have taken. As you can see, it has gained 27% over the past week as the VIX gained 76%, but past performance is not necessarily indicative of future results. In fact, trading the VXX is very tricky and timing is everything.

A deep dive into VXX and long volatility ETFs is beyond the scope of my mission here as I just want to show a simple example of “long volatility” for asymmetric hedging. The succinct reason the VXX didn’t track the VIX index perfectly is because he Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects market participants’ views of the future direction of the VIX index at the time of expiration of the VIX futures contracts comprising the Index. Owning the ETNs is not the same as owning interests in the index components included in the Index or a security directly linked to the performance of the Index. For additional information including the risks associated with VXX and ETNs, please see the VXX prospectus. The bottom line is, to successfully trade the VXX is beyond simply trading its price trend, it also requires understanding its roll yield issues and the VIX term structure.

While CBOE Volatility Index® (VIX® Index®) is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices, I use other measures to observe actual, realized, historical volatility.

Below is the S&P 500 stock index with bands of standard deviation. As you can see, the red arrow shows the price has spread out below the lower volatility band. These volatility bands normally contain the range of price, until it doesn’t. In this case, the volaltity is measured by the standard deviation, so this is a simple observation of the standard deviation shortfall. A price trend can and does trend beyond its normal range.

Bollinger Bands Volatility Expansion SPX $SPY $SPX

In the next chart, I use channels that represent a band of the average true range. In this case, the average true range is adapting more responsive by spreading out faster, so the SPX price trend is still within its lower channel as the price trends down.

Keltner Channels ATR SPX $SPX volatility expansion

The bottom line is, we’re seeing a volatility expansion as I suspected we could.

We’ll see where it goes from here…

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data is deemed reliable, but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

Now we’re seeing some volatility expansion

I suggested in Is volatility setting up for an expansion? we may see volatility increase.

Sure enough, implied volatility, as measured by the VIX, has trended up from 12.16 to 15.30, which implies the expected volatility over the next 30 days has examined from about 12% to 15%.

VIX

The bands around the price trend below use a measure of realized historical volatility (standard deviation) over the past 20 days. As the realized volatility has contracted, it signals the range of prices spreading out has been narrow. This is an uptrending, quiet, market condition. When I see one market condition like this I’m alert for it changing.

bollinger band spx

In the next chart, we observe another channel of volatility around the stock index measured with average true range (ATR) and it has been a tighter band. The stock index price has also been pushing the upper boundary since the beginning of the year.

spx atr channel position sizing

Periods of low and contracting volatility are often followed by periods of higher and expanding volatility.

On the other hand, here we see the realized volaltity of implied volatility has reached its upper band, so if it remains within a normal range, it may remain inside the band. However, it can certainly spike up if the market expects higher movement.

vix volatilty of volatlity

So, Semper Gumby, always flexible.

This uptrend could change.

I know when I’ll exit all my positions if they trend down enough to cut my losses short. I also know what percent of drawdown that would lead to if all of my positions decline together. If I wanted, I could tighten it up to reduce the drawdown if prices fall more. Or, I could hedge with a short index position or go long volatility.

You can probably see how everyone decides what they get from the market.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data is deemed reliable, but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Is volatility setting up for an expansion?

I’m not going to be surprised if we see a VIX volatility expansion this week along with the range of stock prices spreading out.

There are plenty of potential catalysts that could drive volatility and uncertainty higher for those who need a story driving it.

According to Bloomberg:

As Fed officials begin their discussions on Tuesday they will have some more data with which to assess the economy. Personal income, pending home sales and consumer confidence statistics are all due that morning. Then on Thursday, the ISM manufacturing report is expected to show industry is stabilizing and continuing to expand. Friday’s trade data will be pored over for evidence that the skirmish with China is having an effect. Also next week, the Treasury will say on Wednesday how much money it needs to borrow amid rising budget deficits.

For me, the driver of a volatility expansion $VIX will just seem like a normal countertrend from a historically very low point. As vol has contracted into the 12’s it is at the low level of its cyclical range. This is when I start looking for a reversal.

VIX $VIX #VIX VOLATILITY EXPANSION JULY 2019

VIX futures are at a 9.86% contango, so the roll yield is a little steep. That is, the September VIX future is about 10% higher in price than the August VIX price. The difference in the price creates a roll yield those traders who are short VIX options or futures hope to earn.

vix-futures-term-structu

Those of us more focused on the directional trend, especially countertrends, will be more alert to see volatility expand from here. The trouble is, the contango creates a headwind for the ETFs and ETNs we may want to enter long at some point. That’s because they may invest in both the front month and second month, so as they roll forward through time they are selling the lower-priced august to buy more of the higher-priced September. This negative roll yield is why the VIX based ETFs trend down over the long term. To trade them successfully, timing is important, but it’s also not so simple.

The next chart is the S&P 500 stock index with Bollinger Bands around the price trend set at two standard deviations from its 20 day moving average. While the VIX is an implied volatility index based on how the options market has priced options of the S&P 500 index stocks, these bands are measures of realized volatility. Actual volatility has also contracted recently.

bollinger bands realized volatility

Periods of low and contracting volatility are often followed by periods of higher and expanding volatility.

Let’s see how it goes…

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data is deemed reliable, but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

VIX Implied Volatility is Settling Down

The CBOE VIX is settling down again after getting after it last year.

The VIX is designed to measure the 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index call and put options.

The VIX Index is a  measure of the market’s expectation of future volatility, so the market is pricing in less volatility from here.

vix $vix #vix term structure asymmetric hedge

VXV calculates based on a 3-month measure instead of VIX’s 1-month measure. The chart gives us an observation of term structure. Typically, we expect longer dated options like the 3-month to be higher than 1-month because they offer “insurance” for a more extended period. If the 1-month is higher than the 3-month, it means near term implied volatility has spiked, so the market is probably buying the protection of options. Right now the 1-month is lower than the 3-month, so the term structure is back to its normal contango.

By the way, anyone trading volatility or hedging with the VXX ETN should be aware that VXX is maturing on January 30th, 2019. Barclays has created a replacement with iPath® Series B S&P 500® VIX Short-Term FuturesTM ETN (VXXB).

Speaking of CBOE, it will be interesting to see the outcome of the earnings report on February 8th and if the volatility last year improves their profitability.  Blow is an interesting observation of the stock. The stock has declined -31% since its high last February. The orange line is the forward PE Ratio, with the stocks price over its earnings per share “predicted” by analysts. Keep in mind, analyst estimates are often wrong. Their expectations are no sure thing. The red line is the trailing 12 months earnings per share (EPS). The gap down in Forward P/E corresponding to the trailing twelve month EPS is an interesting observation.

cboe earnings report eps

The Forward P/E Ratio can signal analyst sentiment of a stock. If the forward P/E ratio is higher than the current P/E ratio, it indicates decreased expected earnings. A Forward P/E ratio less than the current P/E means expected increased earnings. Charting them below, it doesn’t appear the analyst are overly optimistic about the EPS report. But, what if they’re wrong?

cboe pe eps earnings research stock

We’ll soon learn if options and futures trading in VIX results in profits for CBOE in a volatility expansion. Over the past year, that hasn’t been the case, so maybe it’s time?

cboe earnings from vix optoins trading

We’ll see.

Only time will tell if VIX implied volatility continues to contract and the CBOE stock trends up or down. But, if any company that should profit from directional movement up or down and a volatility expansion, it’s the CBOE. Analysts can get the CBOE stock wrong and the market can get the future volatility wrong,

Let’s see how it unfolds.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

A Tale of Three Vols

I know, you’re thinking this is about the Tennessee Vols.

Nope.

Different vol.

I’m not talking about Tennessee Volunteers, I’m talking about the volatility of the stock market.

Someone asked:

“With the S&P 500 is up 3.43% on Friday, volatility is up, way up. So, why is the VIX down -16%? “

The short answer is the CBOE Volatility Index (VIX) is volatility implied by S&P 500 options prices, so it’s expected future volatility, not actual or realized historical volatility. In fact, the VIX is an estimate of volatility for the next 30 days. Part of the price of S&P 500 options is an estimate of how volatile the S&P 500 will be between now and the option’s expiration date.  This estimate is not directly observed but is implied by how much buyers are willing to pay for options.  If the market has been volatile as it has been recently, option premiums will increase with the volatility expansion. When the stock market is calm and smooth like it was in 2017, options prices will decrease as a volatility contraction. So, the VIX is implied volatility, not historical realized volatility.

Since investors tend to extrapolate the recent past into the future, they usually expect recent calm markets to continue and violent swings to persist. However, we’ve experienced nearly a year of a high volatility regime with the S&P 500 swinging up and down in a range as high as 20%. However, we’ve now seen two high volume up days and the second is considered to be an upward follow-through day. Such a thrust seems to have the options market expecting lower volatility over at least the next month. That’s how I see it. Others may believe its a reaction to the economic news. It is what it is.

What is perplexing to those not familiar with VIX movement is it decreased so dramatically as the price actually gained a lot. Volatility actually expanded, but to the upside, and implied volatility evaporated. That doesn’t sound like a volatility gauge.

Another issue is not all volatile calculations really measure upside and downside vol the same way. Below is the S&P 500 index.

  • The first chart in the next window below the price trend is an average true range (ATR) of the price over the past 14 days.
  • The second chart is the VIX.
  • The chart in the last window is the standard deviation.

spx spy vix $spx $spy $vix atr volatility asymmetric

A few observations:

  1. The price of the S&P 500 has increased sharply the past two weeks.
  2. The VIX is trending down sharply and so is the standard deviation.
  3. The average true range isn’t trending down. It has stayed about the same.

As the price has spiked up, historical volatility as measured by standard deviation is trending down sharply and so is implied volatility. The only measure actually accounting for this wide range of prices (up in this case) is the average true range.

You may be wondering why?

Standard deviation a statistical model that measures the volatility of a price trend. The calculation assumes that two standard deviations should contain 95% of the price data.

The average true range includes the total “true” range of the price trend by comparing highs, lows, and closes, and compares the price change over different days to account for gaps up and down in price.

As you can see, the average true range of price appears to more accurately reflect the volatility as prices spread out. The standard deviation is recovering from the large deviations as the average true range is reflecting remaining day to day volatility.

What does it matter, anyway?

Volatility measures may be used to create indicators for trading signals. For example, in the chart, I added channels above and below the price trend that are 2 times the standard deviation. These bands are expected to include about 95% of price action.

spx spy $spx $spy atr sd vix volatility asymmetric

There are two ways it may be used for tactical trading.

A trend following system may use them to identify a breakout because moves outside the price range are rare. A trend following system expects such strong momentum will continue.

  • When the price breaks out the upside, a trend follower may buy, expecting the momentum of the price will keep trending up.
  • If the price breaks out to the downside, the trend following system may sell (short), expecting the downside momentum to continue.

A countertrend system does just the opposite.

  • If the channel is reached on the upside, the countertrend system will sell, expecting the price will reverse back down within the range.
  • If the price falls to the lower channel, the countertrend system will buy, expecting the price is more likely to trend back up within the range.

I’m just sharing this as an observation to answer a question. We could test these signals to see their results as a system to quantify which one may have a better asymmetric risk/reward. But, for this purpose, we can see how these three volatility indicators are similar or different.

I could have titled this observation “A Tale of 4 Vols” since we can observe the distinctions between “lower volatility” and “higher volatility” by simply looking at the price trend. Over the past two years, we’ve certainly observed a period of low vol change into high vol. I call it a volatility expansion and though, for me, using the VIX and other indicators signaled the possible change, the price trend itself is the final arbiter.

trend following stocks stock market asymmetric risk reward

By the way, what about the other vol? The Tennessee Vol? Why do they call Tennessee the “Volunteer State” and the Tennessee Volunteers?

Appalachian Magazine shares the story:

“The proclamation went out from Nashville that the federal government needed 2,600 volunteers to assist in the war with Mexico… Within a week’s time, more than 30,000 Tennesseans responded to the call to arms.  And it was from this overwhelming show of patriotism that the State of Tennessee not only assisted in winning the outright sovereignty of the State of Texas, but also in securing its lasting title as The Volunteer State.”

So, there you have it.

I guess I could have titled this observation “A Tale of Five Vols.” You can probably see how observations can spread out to a wider range and become more volatile. It’s even true for the topic of volatility.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Observations of the stock market downtrend

Observations of the stock market downtrend

In the last observation I shared about the stock market, “The stock market trends up with momentum,” we saw the stock market reverse back up with strong momentum. The S&P 500 stock index had declined about -7% from its high, then reversed back up 3%. I discussed how investor behavior and sentiment drives market prices. Many investor sentiment measures signaled investor fear seemed to be in control, driving down prices. Volatility had spiked and then started to settle back down. Many individual stocks in the S&P 500 had declined enough to signal shorter-term downtrends, but then they reversed up. I closed by saying:

In summary, today was a strong upward momentum day for the stock market and most stocks participated in the uptrend. After sharp declines like we’ve seen this month, the stock market sometimes reverses up like this into an uptrend only to reverse back down to test the low. After the test, we then find out if it breaks down or breaks out.

One day doesn’t make a trend, but for those who are in risk taker mode with stocks, so far, so good.

The part I bolded with italics has turned out to be the situation this time.

Below is a year to date price trend of the S&P 500 stock index. As of today, my observation “the stock market sometimes reverses up like this into an uptrend only to reverse back down to test the low” is what we are seeing now.

stock market trend

I’ve always believed investment management is about probability and possibilities, it’s never a sure thing. The only certainty is uncertainty, so all we can do is stack the odds in our favor. As I said before, “After the test, we then find out if it breaks down or breaks out.” 

The positive news is, investor sentiment measures are reaching levels that often precede short-term trend reversals back up.

The bad news is if the current trend becomes a bigger downtrend these indicators will just stay at extremes as long as they want. We have to actively manage our exposure to loss if we want to avoid large losses, like those -20% or more that are harder to overcome.

Down -10% is one thing, down -20% is another. Any investor should be willing to bear -10% because they will see them many times over the years. Only the most passive buy and hold investors are willing to bear the big losses, which I define as -20% or more.

Nevertheless, I see some good news and bad, so here it is. I’ll share my observations of the weight of the evidence by looking at relatively simple market indicators. I don’t necessarily make my tactical decisions based on this, but it is instead “market analysis” to get an idea of what is going on. Observations like this are intended to view the conditions of the markets.

Fear is the dominant driver. 

The Fear & Greed Index tracks seven indicators of investor sentiment. When I included it a week ago, it was at 15, which is still in the “Extreme Fear” zone. The theory is, the weighting of these seven indicators of investor sentiment signals when fear or greed is driving the market. Clearly, fear is the dominant driver right now.

fear greed index investor sentiment behavioral finance

At this point, we can see investor sentiment by this measure has now reached the low level of its historical range. In this chart, we can see how investor sentiment oscillates between fear and greed over time in cycles much like the stock market cycles up and down.

fear and greed back test over time investor sentiment indicator

I believe investor behavior is both a driver of price trends, but investors also respond to price trends.

  • After prices rise, investors get more optimistic as they extrapolate the recent gains into the future expecting the gains to continue.
  • After prices fall, investors fear losing more money as they extrapolate the recent losses into the future expecting them to get worse.

Investor sentiment and price trends can overreact to the upside and downside and the herd of investors seems to get it wrong when they reach an extreme. We observe when these kinds of indicators reach extremes, these cycles are more likely to reverse. It is never a sure thing, but the probabilities increase the possibility of a reversal. But, since there is always a chance of a trend continuing longer in time and more in magnitude, it is certainly uncertain. Since there is always a chance of a bad outcome, I  have my limits on our exposure to risk with predetermined exits or a hedge.

Speaking of a hedge. 

I started pointing out my observation several weeks ago of a potential volatility expansion. If you want to read about it, most of the past few weeks observations have included comments about the VIX volatility index. Over the past few days, we’ve observed a continuation in the volatility expansion.

vix hedge volatility expansion asymmetric hedge asymmetry

Implied volatility has expanded nearly 100% over in the past 30 days.

vix volatility expansion trading

As a tactical portfolio manager, my first focus is risk management. When I believe I have defined my risk of loss, I become willing to shift from risk manager to risk taker. I share that because I want to point out the potential for hedging with volatility. Rather than a detailed exhaustive rigorous 50-page paper, I’m going to keep it succinct.

My day job isn’t to write or talk about the markets. I’m a professional portfolio manager, so my priority is to make trading and investment decisions as a tactical investment manager. I’m a risk manager and risk taker. If I never take any risk, I wouldn’t have any to manage. The observations I share here are just educational, for those who want to follow along and get an idea of how I see things. I hope you find it helpful or at least interesting. It’s always fun when it starts new conversations.

To keep the concept of hedging short and to the point for my purpose today, I’ll just share a simple chart of the price trend of the stock index and the volatility index over the past 30 days. The stock index has declined -8.3% as the implied volatility index expanded over 95%. You can probably see the potential for a hedge. However, it isn’t so simple, because these are just indexes and we can’t buy or sell the VIX index.

vix volatility as a hedge stock market risk management

The purpose of a hedge is to shift the risk of loss from one thing to another. The surest way to reduce the possibility of loss is to simply sell to reduce exposure in the thing that is the risk. That’s what I do most of the time. For example, when I observed a potential volatility expansion, I reduced my exposure to positions that had the possibility of loss due to increased volatility. Once prices fall and volatility contracts, maybe we increase exposure again to shift back to risk-taking. If we take no risk at all, we would have no potential for a capital gain. So, tactical portfolio management is about increasing and decreasing exposure to the possibility of gain and loss. If we do it well, we create the kind of asymmetric risk/reward I aim for.

So, any hedging we may do is really just shifting from one risk to another, hoping to offset the original risk. Keep in mind, as I see it, a risk is the possibility of loss. I’ll share more on hedging soon. I have some observations about hedging and hedge systems you may find interesting.

Most stocks are participating in the downtrend. Below is an updated chart of the percent of the stocks in the S&P 500 that are above their 50-day moving average. If you want to know more about what it is, read the last observations. The simple observation here is that most stocks are declining.

stock market breadth risk indicator

Much like how we saw investor sentiment cycle and swing up and down, we also see this breadth indicator oscillate from higher risk levels to lower risk levels.

  • After most stocks are already in uptrends, I believe the risk is higher that we’ll see it reverse.
  • After most stocks have already declined into downtrends, it increases the possibility that selling pressure may be getting closer to exhaustion.

The good news is, at some point selling pressure does get exhausted as those who want to sell have sold and prices reach a low enough level to bring in new buying demand.

That’s what stock investors are waiting for now.

These are my observations. I don’t have a crystal ball, nor does anyone. I just predetermine my risk levels in advance and monitor, direct, and control risk through my exits/hedging how much I’m willing to risk, or not. We’ll just have to see how it all unfolds in the days and weeks ahead.

Only time will tell if this is the early stage of a bigger deeper downtrend or just another correction within the primary trend.

I hope you find my observations interesting and informative.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

The stock market trends up with momentum

When the stock market indexes swing up or down 1% or more I try to share my observations of the directional trend and changes in volatility. Continuing from my observation yesterday in Observations of the stock market decline and volatility expansion when I shared:

The good news is, we’ve now experienced some volatility expansion, stocks have now pivoted down to the lower end of their cycles, so maybe volatility will contract and stock prices resume their uptrend.

We’ll see.

Well, today we saw.

The U. S. stock market gains were broad across all sectors. Communication Services, Consumer Discretionary, Healthcare, and Technology were the relative momentum leaders.

stock market trend sector ETF momentum

Continuing with the % of S&P 500 stocks above their 50 day moving average as breadth indicator was another indication of broad upward momentum. 86% more stocks are trading above their shorter-term trend, an expansion from a low level. For those of us who like to enter trends early in their stage, this is a positive sign of improvement for the stock market.

percent of stocks above below 50 day moving average trend following momentum

We observe the same in the percent of stocks trending back above their longer-term trends. There was a 16% expansion in the stocks in the S&P 500 index trending above their 200 day moving average. The longer-term trend indicators are slower to respond, but this is more evidence of positive directional movement.

stock momentum percent of stocks above 200 day moving average trend following asymmetric

This is happening at a time when many investor sentiment indicators suggest fear has been driving stocks recently. A simple example is the Fear & Greed Index, which reached “Extreme Fear” a week ago.

CNN FEAR GREED INDEX SENTIMENT

As a portfolio manager for the past two decades, I have observed investor sentiment oscillate between fear and greed, but as a contrarian pendulum. Most investors feel the wrong feeling at the wrong time.

  • After prices rise, investors get more optimistic as they extrapolate the recent gains into the future expecting the gains to continue.
  • After prices fall, investors fear losing more money as they extrapolate the recent losses into the future expecting them to get worse.

What happens, though, is market trends move in multiple time frames of cycles up and down. Prices can overreact to the upside and downside and the majority of investors seem to get it wrong.

The level and direction of implied volatility is an indication of investor sentiment. I’ve shared my observations of the volatility expansion and noted some volatility contraction yesterday. So far, the volatility expansion has reversed to contraction, so the expected volatility as implied by options prices now suggests the market expects lower volatility in the weeks ahead.

VIX VOLATILITY CONTRACTION EXPANSION ASYMMETRIC RISK HEDGE ASYMMETRY

But, just as I pointed out on September 25th in VIX level shows market’s expectation of future volatility implied volatility can get it wrong. I pointed out then the implied volatility was very low signaling to me the market may have been wrong to expect such low future volatility, so it can reverse back up again.

In summary, today was a strong upward momentum day for the stock market and most stocks participated in the uptrend. After sharp declines like we’ve seen this month, the stock market sometimes reverses up like this into an uptrend only to reverse back down to test the low. After the test, we then find out if it breaks down or breaks out.

One day doesn’t make a trend, but for those who are in risk taker mode with stocks, so far, so good.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Observations of the stock market decline and volatility expansion

Observations of the stock market decline and volatility expansion

On September 25th I shared in VIX level shows market’s expectation of future volatility when I pointed out a low level of expected volatility as implied by the VIX index.

I said:

The current level of the VIX index has settled down to a lower historical level suggesting the market expects the future range of the price of the S&P 500 to be lower. Below is the current level relative to the past year.

I went on to explain my historical observations of volatility cycles driven by investor behavior:

The VIX Index is intended to provide a real-time measure of how much the market expects the S&P 500 Index to fluctuate over the next 30 days. The VIX Index reflects the actual order flow of traders

Since investors tend to extrapolate the recent past into the future, they usually expect recent calm markets to continue and violent swings to persist.

After the stock market declines and volatility expands, investors extrapolate that recent experience into the future and expect volatility to continue. Sometimes it does continue, but this time it gradually declined as the price trend became calmer.

When markets have been calm, traders and investors expect volatility to remain low. Before February, the VIX implied volatility had correctly predicted low realized volatility for months. But, both realized and expected volatility was so low that many investors were shocked when stock prices fell sharply, and volatility expanded.

When the market expects volatility to be low in the next 30 days, I know it could be right for some time. But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

I shared the chart below, showing implied volatility at the low end of the cycle over the past year:

Since that date, we’ve indeed witnessed a volatility expansion of more than 90% in the VIX index and a decline in the S&P 500 stock index over -6%.  Implied volatility has expanded and stocks declined. As implied volatility is now starting to contract, below we can see the recent expansion as it trended from 12 to 24. Today its back to its long-term average of 20.

Stock market indexes, both U. S. and international, have declined 6 – 7% from their highs.

At this point, this has been a normal short-term cycle swing in an ongoing uptrend that is frequently referred to as a “correction.”

To be sure, we can see by looking at the % drawdowns in the primary uptrend that started in March 2009.

Markets cycle up and down, even within overall primary uptrends. As we see over a nine-year period, the current decline is about average and half as deep as the largest declines since 2009.

You can probably see what I meant by situational awareness of the markets cycles, trends, and volatility levels.

It isn’t enough to just say it or write about it. My being aware of the situation helps me to do what I said, which is worth repeating:

But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

As far as the stock market condition, I like to see what is going on inside. Just as volatility swings up and down in cycles, so do price trends. As I’ve pointed out before, I observe prices swinging up and down often driven by investor behavior. For example, many investors seem to oscillate between the fear of missing out and the fear of losing money.

“The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.” – Warren Buffett

One visual way to observe the current stage is the breadth of the stock market as I shared last week in The Stock Market Trend. Below is the percent of stocks in the S&P 500 index trending above their 50 day moving averages often used as a short-term trend indicator. This is a monthly chart since 2009 so we can see how it oscillates up and down since the bull market started. At this point, the number of stocks falling into short-term downtrends is about what we’ve seen before.

stock market breadth asymmetric risk

The risk is: this continues to be an aged old bull market, so anything is possible. That is why my focus every day is situational awareness. But, there is always a risk of a -10% or more decline in the stock market, regardless of its age or stage.

The good news is, we’ve now experienced some volatility expansion, stocks have now pivoted down to the lower end of their cycles, so maybe volatility will contract and stock prices resume their uptrend.

We’ll see.

All that is left to do is observe, be prepared, and respond tactically as it all unfolds.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

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