US political intrigue…a resurgent Labour party in the UK polls…North Korea…Syria…the Manchester bombing…Greek debt (again)…potential early Italian elections…Brazilian impeachment…looming protectionism and trade wars…interest rates creeping up……Venezuelan meltdown…high US stock prices by any measure. Does this sound like a low risk environment for investors? A key measure of US stock market risk says it does. Either US traders are taking record levels of valium or we’re witnessing insane complacency.
Some time in the last few days I read an argument that went something like this: bubbles never form in low volatility environments, with prices grinding steadily higher. Instead bubbles are high volatility environments and surrounded by massive hype about sunlit uplands and “new paradigms”.
To be fair the person making this assertion was comparing US stocks to the obvious new bubble in Bitcoin (see here). But a quick look at the angle of travel of the S&P 500 should provide plenty or cause for concern, at least when compared with the run up to the last two peaks.
Today I’m not going to spend a lot of time discussing valuations in the US stock market. I’ll just remind you that the S&P 500 is substantially more expensive today than at its last peak in late 2007. That’s on all of these measures (and more): price-to-sales, price-to-earnings, price-to-book and cyclically adjusted price-to-earnings (see here for more on that last one).
With that out of the way, let’s introduce today’s point of interest. It’s something that’s often referred to as “the fear gauge”. Many of you may already know that this refers to the Chicago Board Options Exchange (CBOE) volatility index, known as the VIX.
The VIX has recently reached record lows – which means lower than at any time since it was set up in the early 1990s…which is probably longer than most professional traders and fund managers have had a job. Given the VIX’s reputation as a fear gauge the implication is that traders are particularly devoid of fear right now.
Which is strange, given the state of the world. And a notable cause for concern. We’re now close to a decade since stocks last topped out in October 2007. With valuations at high levels, this increasingly looks like the calm before a storm.
Before I go any further let’s back up and make sure we understand what the VIX actually measures. In general terms it’s a measure of how much traders expect stock prices to swing around. More specifically, it reflects the current expectation in the options market of annualised price volatility for the S&P 500 index of US stocks.
The CBOE works out the VIX by looking at the prices of a wide range of call and put options, a kind of financial derivative contract, on the S&P 500 index and with 30 days to expiry. For a full explanation of the world of stock put and call options, and why I think in general they should be left to professional traders, see “Why I never trade stock options”. But, notwithstanding the perils of trading options yourself, a look at the VIX still gives us some interesting insights.
Put simply, the price of an option – known as the “premium” – includes an element that’s known as “implied volatility”. Once you know observable elements that contribute to the premium – such as time to maturity, current market price of the underlying asset and the option’s strike price – you can reverse engineer how much is baked into the pricing formula for implied volatility. VIX is this measure for options on the S&P 500 index.
Higher implied volatility means a higher option premium, all other things being equal. This is because the more that underlying prices – in this case of the S&P 500 – swing around the more chance that the option owner will have a chance to make a profit. So they should be prepared to pay a higher premium to buy the option.
Of course this has another important implication. The higher the volatility the higher the chance that the option seller will make a loss. Hence, when option sellers anticipate high volatility they charge a high premium, and vice versa.
As I pointed out in previous article about this area (see here), when it comes to trading options: “The expected cash flows will net out if the option is appropriately valued.” This was a quote from something known as the “Gold Book” which was used as a training manual at UBS, the global investment bank and a previous employer of mine.
Put another way, if options are always priced correctly then you can’t make money out of them – over many trades over a long period of time. Winners will be offset by losers. When the price is right they’re ultimately a zero sum game. For you to make money with options trading, over time, you have to know precisely when the options are over or under priced. (Or you have to be the investment bank that charges to be the intermediary between buyers and sellers.)
With investment banks and brokers as your trading counterparties, and clipping commissions too, it’s highly unlikely that private individuals can come out on top with options. That’s especially true of those without a professional trading background. Taken as a group, private investors are bound to lose from options, even if a dedicated few manage to do well.
(Note this is different to everyone simply owning appreciating stocks of dividend paying companies. There’s no reason that everyone can’t make money that way, at least with sufficient patience and over the long run.)
What’s VIX telling us?
Anyhow, let’s get back to what’s going on now. The VIX is ultra low, and touched its lowest level ever just a few days ago, on 26th May. Here are a couple more charts showing where things stand:
By the way that short spike in the last month was when the market fell a couple of percent on 17th May and then recovered quickly over the following days.
As for now, this makes options cheap for buyers, at least relative to their history. It also means options sellers are receiving little compensation for the risk they’re taking on. And remember the stock market is already clearly toppy. Which is another way of saying it’s more likely to fall sharply than to rise sharply.
So I reckon that, at the present time, buyers of put options – who are protecting against a market fall – are most likely getting a much better deal than put sellers. The latter are selling cheap insurance against a market fall precisely when the risk of a claim is relatively high. Beware if you’re playing the game of selling put options as a way to generate extra income in the short term.
Actually maybe that’s the problem. There are simply too many income seeking option sellers around – for puts or calls – in relation to the demand from buyers. This would depress premiums and hence the implied volatilities.
In any case, the VIX “fear gauge” is still kicking around record lows. That suggests an extreme level of market complacency surrounding the potential for shocks and surprises.
Either that or US traders are drugged up to their eyeballs on valium. This is just another sign that adds to my growing feeling of unease that we’re reaching a tipping point in US stocks.
Stay tuned OfWealthers,
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