Are You Ready For A 60% Surge In Volatility?

Steven Sears had a good piece in Barrons over the weekend disussing the low level of the VIX.  As the market has continued to melt higher we’ve seen increasing levels of complacency as investors become increasingly comfortable with the market and their belief that it simply cannot decline.  While the economic fundamentals certainly back this outlook it’s always nice to have an insurance contract in your back pocket just in case.  In this case, it might be a bit of covered call writing or some outright VIX purchases.

Sears notes that MKM analysts believe the VIX could jump 60%+ in the coming months.   Not a bad insurance contract to have just in case.  Better yet, it doesn’t keep you out of the game entirely.  Remember, you miss 100% of the shots you never take, but with a hedge you’re shooting free throws as opposed to three pointers:

“ONE SELDOM-DISCUSSED REALITY of the modern options market is that the computers that control pricing models sometimes get out of tune with market reality. As stocks grind higher, as occurred in the fourth quarter, the models anticipate lower implied volatility because stock prices have advanced in the past. The past few days saw institutional investors buying bearish puts to protect against a decline, but the action wasn’t significant enough to cause a rapid increase in implied volatility.

A lesson of the past year is that wise investors buy volatility when it seems too low, and sell when it is too high. The volatility metronome also works for timing stock trades.

Risk premiums, as measured by the Chicago Board Options Exchange Volatility Index, are too low now, given the cross-currents roiling the surface of the stock market. This typically marks a good time to buy defensive index options to hedge against broad-market declines and volatility spikes.

With VIX around 18, Jim Strugger, MKM Partners’ derivatives strategist, is telling clients to buy VIX Feb. 21 calls and sell VIX Feb. 30 calls to protect against an earnings-season volatility spike that could temporarily interrupt the bull advance.

“After being bullish on equities since late August, and riding this volatility wave lower, we’re saying, ‘get ready for a VIX spike to 30,’ ” Strugger says.”

Source: Barrons

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by Andrew Wilkinson, Senior Market Analyst at Interactive Brokers

Read more at The Pragmatic Capitalist