Volatility and Risk

Basics of Volatility Metrics

Volatility (vol) describes the liability for something to change rapidly and unpredictably, especially for the worse. When markets experience elevated volatility, price swings are accentuated, and corrections occur. When volatility stays muted, asset prices generally grind higher. Similarly, if volatility enters an uptrend, the price action in the underlying asset is likely trending lower.

The higher the vol spike, the more severe the correction. The VIX is the most commonly referenced volatility index. It refers to vol on the S&P 500. There are lesser-known indexes that measure volatility in other groups or assets.

• VXN: Nasdaq 100 → The Nasdaq is heavy with growth stocks, which are more vulnerable to economic slowdowns.

• RVX: Russell 2000 → Small to mid-cap companies (worth < $10 billion)

  → Less likely to reap the benefits of economies of scale

  → More sensitive to business cycle risk, thus more exposed to weakness during economic contraction as capital flows from smaller companies to the safety of large cap firms

  • For more on concentration risk, see last post: Rolling Bubbles

As they are more susceptible to the turning of the economic wheel, growth and small-to-mid cap stocks often have a higher beta coefficient. “Beta” refers to a stock’s volatility compared to an overall index (generally the S&P 500). RVX and VXN tend to trend higher than the VIX because the underlying equities, on average, have higher beta.

Other notable volatility measures:

• GVZ: Gold Volatility

• OVX: Oil Volatility

• The MOVE index: Bond Market Volatility

Different asset classes experience different ‘norms’ in their levels of realized volatility. The order of volatility by asset class is generally as follows:

• Currencies Vol < Fixed Income < Equities < Commodities < Crypto Vol

In practice, a volatility reading of 30 is relatively low when analyzing the oil market, but relatively high when looking at the VIX. Simply put, there are three categories of volatility when assessing the stock market.

1. VIX < 20: This is an investor’s market. Buy the dip.

2. 20 < VIX < 30: This is a trader’s market. Daily price swings between 1% - 2% are common.

3. VIX > 30: Imagine riding a roller coaster for your first time and not knowing what to expect. This is a seller’s market. Aggressive rallies are quick to fade, but it is not unusual to see a 3-4% bounce before sellers return. This level of vol is unkind to novice traders. But in historical context, VIX > 30 always presents opportunities for long-term investors, as broad markets are usually down 10-20% already. The challenge is not to cut your hand when you catch the falling knife.

Currencies Volatility

Can you imagine if the US Dollar traded like Bitcoin? From its bottom in January 2021, the USD appreciated 28.7% before peaking in Sept 2022 and has since retraced 10% lower. The move higher is relatively large for a currency, as it preceded the largest interest rate hiking cycle in 40+ years. This is the world’s reserve currency.

Bitcoin bottomed during the onset of the pandemic in March 2020 and proceeded to rise over 1581% before peaking in October 2021. It then corrected 78.5% to its bottom in November 2022 and has since risen 231%, justifying its reputation for attracting traders with a gambler’s mentality.

Volatility measures a market’s stability. The dollar is the most fundamental element of economic infrastructure. If it experienced the type of volatility observed in other asset classes, a global economy would not be feasible. That is why Bitcoin is unlikely to replace the dollar as the world reserve. Digital blockchain and distributive ledger technology may have its place in the future of markets and finance, but as long as crypto assets maintain elevated volatility, no single one of them has the store-of-value characteristics necessary to be considered a currency, let alone the world reserve.

What about gold? As seen above, GVZ trends lower than the VIX or other measures of volatility. That’s because gold trades more like a currency than a commodity. But it is rather difficult to use as a medium of exchange. Perhaps a digital currency may arise that tracks the price of gold and can be traded on distributive ledger…

Commodities Volatility

Let’s take a look at natural gas, compared to the dollar in terms of percentage change over a three-year period.

Natural gas is the most volatile commodity, partly because it is a localized market. Supply must come via pre-existing pipeline, and local weather events or supply disruptions can cause abrupt and dramatic price changes. The LNG (liquid natural gas) market is growing quickly and will help to globalize this market.

Generally, nat gas prices fluctuate between $2-$4 per MMBtu. It is not uncommon to see weekly prices changes of 30-60 cents per unit. That doesn’t sound like much, but 5% to 25% weekly price swings indicate a severely unstable market (imagine if the S&P 500 routinely moved 10% in a single week).

During the pandemic, prices jumped over $10/MMBtu. And leveraged contracts can be a killer. This is why traders refer to the natural gas market as the ‘widow-maker’.

In short, volatility dynamics should factor into an investor’s decisions around position sizing. The savvy risk manager may have 10% of their portfolio in long-term bond ETF but is unlikely to allocate that percentage of capital to a position in oil or cryptocurrency. The more volatile an asset, the smaller the maximum allocation should be.

Application of Vol Studies

Implied volatility is what the market is pricing in ahead of time. Realized volatility is what actually occurs in the present. Let’s look at a snapshot from late January.

This table measures implied volatility levels of each major sector in the US equity space. Implied vol vs realized vol percentages are determined by activity in the market for put options. Investors purchase puts in an effort to protect from downside price movement in the underlying asset. The larger the premium paid for put options, the more investors are buying protection on the corresponding sector. Increased put buying means there is less room for downside price action because investors have already prepared for it (i.e. the risk is priced in).

• On 1/24, the S&P (SPY) had an IVOL premium of 37%, compared with the IVOL discount on the Russell 2000 (IWM) of -3%. Investors were hedging against downside in SPY more than downside in IWM.

• Keep in mind where the volatility indexes are trading as well.

  • On 1/24, RVX closed at 21.76. VIX closed at 13.14.

• So, in addition to decreased protection buying on the Russell index, volatility was elevated compared to the S&P.

Knowing this, in combination with how markets are currently positioned, helps investors time the market for entry as buyers or sellers.

The commitment of traders report shows how the market is positioned based on open interest in the futures markets. Looking at the Russell 2000, on 1/24, traders were net long 15,299 futures contracts on this index. We can see this number is near the 3-year max of 21,422 contracts (for comparison, look at the 3-year minimum position, when traders were net short 120,386 contracts).

• Z-Scores measures the standard deviation over a specific time period. On 1/24, the 1-year z-score on the Russell 2000 measured 3.40

• Generally, a z-score greater than (or less than) 2.0 indicates an overbought (or oversold) market.

Let’s put it all together. On 1/24, the Russell 2000 was experiencing increased volatility compared to the S&P. Additionally, positioning was skewed into overbought territory with little downside protection being purchased by investors. Since then, the Russell experienced a 2% drawdown, while the S&P correction was contained within 0.5%. As of 2/6, RUT has not returned to the levels seen last month, and SPX has made new highs multiple times.

In summary, volatility dynamics and market positioning can be studied in conjunction to see where risk is being priced in and what sectors or assets may be vulnerable to downside price action.

A Note on Economic Bellwether Events

Large movements in markets often occur in response to the release of surprising economic data. This may come in the form of marginally hawkish/dovish Fed policy, lower-than-expected inflation figures, or more recently, stronger-than-expected labor data… to name a few. Keep in mind:

• The term “hawkish” refers to restrictive policy or speech.

• “Dovish” refers to accommodative rhetoric.

The January non-farm payrolls report released on 2/2 indicated the economy added 353,000 jobs that month, more than twice the consensus number of 175,000.

• This pulled up the estimates for Q1 GDP, strengthened the dollar, and boosted interest rates. A stronger economy does not need more accommodative monetary policy (decreasing expectations of Fed rate cuts in March).

Take a look at how short-term volatility was priced headed into February.

Today, markets trade primarily on money flow rather than economic fundamentals. Short term options trading dominates price action, and the structure of short-dated volatility is anchored to economic data release dates.

• The red arrow points to the 1/31 Fed meeting. The increase in implied vol shows investors were hedging long positions ahead of the announcement. Short term IVOL was priced near 10 on 1/29, and the curve indicated a move above 14 into the meeting.

  • The announcement was more hawkish than expected (i.e. less accommodative), so equity prices corrected as the VIX jumped to realize that higher level of volatility.

Money managers price up volatility around these events to protect their portfolios from a ‘hawkish surprise’. Since accommodative policy boosts asset prices, hawkishness often causes a pullback in markets. This is when ‘smart money’ will cover their hedges and lock in gains from downside bets. If the announcement or data release had been dovish (i.e. weaker-than-expected, or more likely to usher in the easing of monetary policy), equity markets would move higher, and hedges may not pay off, but portfolios would still benefit from the appreciation of underlying stock prices.

• Hence the Wall St. adage: “Bad News is Good News”

Ultimately, it is important to consider upcoming economic events when deciding when and where to deploy capital in the markets. Short term vol structure can indicate how market participants are positioned going into these events.