About that Volatility = Complacency Claim…

Here’s how the usual reporting on low volatility goes…

There’s Low Volatility because the VIX is low, and the VIX being low reflects investors paying less for future downside protection, and paying less for downside protection means investors are less concerned (or aware) of the possibility of downside… so low volatility means these investors are becoming more “complacent”.  What exactly does complacent mean, we looked it up, via dictionary.com:

“pleased, especially with oneself or one’s merits, advantages, situation, etc., often without
awareness of some potential danger or defect; self-satisfied.”

It’s kind of like a person foregoing hurricane insurance because there hasn’t been one in a while. Their recent good fortune of no hurricanes blowing their house down has made them complacent about the possibility of future hurricanes.

The structure of the VIX leads to this low volatility = complacency argument. The Chicago Board Options Exchange’s Market Volatility Index, or the VIX, measures the implied volatility of S&P 500 index, representing investors’ expectations of volatility in the benchmark equities index over the next 30 days.  Higher VIX values indicate anticipation of higher stock market volatility while lower VIX values indicate the expectation for lower stock market volatility. With stock markets tending to ‘take the stairs up, and the elevator down’ as the old saying goes, higher volatility is associated with lower prices most of the time. So, if investors think equities are going lower, they think it will be accompanied by increased volatility, and therefore will be willing to price the VIX higher.

So….we’ll concede that a Low Vix can represent a certain amount of complacency and lack of awareness of possible downside (or upside spikes for that matter) among investors in equities.

But does it follow that low volatility in say, Bonds, means that bond investors are becoming more complacent. While this is mostly semantics and likely only of interest to the most nerdy among you, does it follow that low volatility in Bonds as measured by tight ranges means there is complacency in that market?  We sort of think no. You see, volatility in nearly everywhere but the VIX is measured not by the prices of options to extrapolate the expected volatility over the next 30 days – but instead by the observed volatility over the most recent period, be it 30 days or 100 or the past year.

And that’s the rub… when we say that there’s low volatility in a market like bonds or the Euro Currency because the ranges have contracted, and that means there’s complacency (like we did in our “Complacency Everywhere” piece last week), we’re missing that the tighter ranges are what happened, versus the VIX reading being a measure of what investors believe will happen.  Now, of course, investors being humans – they often project what just happened onto what they think will happen, so there is a high correlation between the observed volatility and expected volatility.

But you can see intuitively that these aren’t the same thing. The observed volatility being low simply means investors were not faced with any market moving information or outside forces over the observed period. It doesn’t necessarily mean those investors are becoming complacent, i.e. – pricing in low volatility expectations moving forward. Luckily, the CBOE came out with some VIX-index like products a while back which allow us to test out this observed versus implied phenomenon. You can see from the charts that while observed volatility is at multi-year lows, the expected volatility is actually at multi-month highs.

Bonds:

Observed volatility = the tightest 10 Yr Treasury Yield 3 month range in 35 years

Expected Volatity = CBOE/CBOT 10-year U.S. Treasury Note Volatility Index – VXTYN (below)

Bonds Vix(Disclaimer: Past performance is not necessarily indicative of future results)

Euro Currency:

Observed volatility = the tightest consecutive monthly ranges in the Euro since inception

Expected Volatility = CBOE EuroCurrency ETP Volatility Index – EVZ (below)

Eurocurrency Vix(Disclaimer: Past performance is not necessarily indicative of future results)

So next time someone (like us) tells you investors are complacent because there’s low volatility – double check their inputs. Are they saying low volatility using the expected volatility of that market looking forward, or the observed volatility looking backwards?  We couldn’t agree more that tighter ranges and a low VIX portend a more volatile climate coming up (not a lower one), but the slight problem in the low volatility = complacency argument didn’t sit so well with us over the weekend… we feel better now for having gotten it off our chest.

Write a Comment

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

logo