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The volatility to come

This article first appeared in the Australian Financial Review

Before you check the chart, try this quick quiz. Is share market volatility high or low?

If you’re not a professional option trader your answer could be “high”. We live and invest in a time of blaring headlines, heightened risk awareness and lightning quick computer assisted responses to every shift in market thinking, every data release.

However the numbers do not support the perception. The chart is the Australian VIX (volatility index) from 2012 to the present. It is not the volatility of the index itself, but a measure of the estimates of volatility made by professional traders. This “implied volatility” is found by reverse engineering the prices of options traded on the ASX.

Implied volatility is a sincere expression of opinion because derivative traders’ careers live or die according to the accuracy of their estimates. The VIX tracks measures of the actual day to day changes in the index quite closely.

Australia 200 – Volatility Index (VIX)

Source: Bloomberg

The VIX generally moves in the opposite direction to the share market. The spikes on the chart all correspond to significant sell-offs. When fear and uncertainty grip markets, investor demand for risk management tools such as options increases significantly. This induces option traders to lift their prices, resulting in higher implied volatilities, and a higher VIX.

This dynamic gives the VIX its nickname – the fear and greed index.

The chart shows that relative to the last five years, volatility is at lower levels. The ASX began calculating the VIX in 2008. The lowest reading ever occurred in 2014 at 9.6%. Currently around 11.5%, the VIX is nowhere near the high point of 63.9% (recorded in the wake of Lehman Brothers’ collapse in 2008) or the spike to 30.3% in Q1 2016 as global markets tumbled on fears of a slowing economy in China.

In other words the VIX index is displaying low levels of fear. Greed and complacency are indicated. This contrasts strongly with the gut feeling of many investors.

Many traders think this is unlikely to last long. The list of possible risks arising in 2017 is long and comprehensive. As the world’s central banks start their move away from accommodation and towards a more “normal” monetary stance the risks for markets and asset prices increase. Political disaffection is on the rise in Europe, the USA and locally. Populism is resurgent and with it the risks of economically damaging policy decisions. Throw in a moribund economy in Japan and ongoing systemic threats to the global banking system in Europe and there are many reasons to fret.

There are other possible and plausible negative developments. It must be said that there is no evidence at this stage to support doom scenarios, but sentiment can deteriorate rapidly. The other side of the coin is a clearly improving global economy, and share markets near multi- year and/or all-time highs. And counter-intuitively one of the most punishing investment choices over the last few years was cash, delivering chronic underperformance.

These conditions create a quandary for investors. 2017 may be a very difficult year.

If markets follow the pattern of 2016 we are likely to see a further increase in the volatility of volatility. Periods of calm and little movement, with possible gains, may rapidly give way to wildly swinging markets, which then settle to calmness again. There are a number of possible strategic investor responses to the forecast difficult conditions.

Diversification is a powerful risk management tool. However, when all asset prices fall it offers no protection, as many investors discovered in 2008. Instead, investors may consider using derivative tools to protect their wealth.

In particular, asymmetric risk profiles may trump all other strategies this year. As an example, a portfolio of shares that is broadly in line with the index may be combined with an index put option (the right to sell).  If the market rises the investor enjoys the benefits, but loses the amount paid for the put. The scenario is different in a falling market. The portfolio loses value, but the put option rises in value as the market falls. If properly constructed this strategy may see an investor profit from a falling market. Whichever way the market goes, the investor continues to receive dividends from their shareholdings.

There is a cost involved. The buyer of a put option pays a premium, but the cheapest time to buy any option is when volatility is low. At the time of writing, a put option offering protection at 5700 for three months cost 81 index points. This equates to a cost of around 1.4% of the value of the portfolio.

Any decision about this type of strategy is up to individual investors. At current prices investors would essentially give up most of their dividend yield to protect their portfolio for the whole year (options prices are very likely to fluctuate). Taking advantage of periods of low volatility to buy cheaper options could be an effective response to anticipated conditions. Some investors may consider the ability to sleep well at night regardless of market moves well worth the price.

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