What is the new standard on the stock market when it seems normal no longer exists?
Covid 19 and the havoc it has created in global economies is unlike anything we’ve seen before. Yet when we look at the stock charts, they keep going up. We have bad jobs data – markets react and go up. We have a low CPI – the markets are going up. Housing data is lacking – markets are rising. It’s like bouncing off Teflon. What once caused dissension in the markets is now causing the opposite. In this upside down world, it has become the norm.
From March 18, 2020 until now, we have had the following gains:
So, we ask how the hell is this going? How come the markets react positively to bad economic news? The continued slow economic recovery. The biggest debt this world has ever known. What is it that fuels all of this on this earth? It took me a while to understand, but it’s simple.
In short, these markets love bad news because it forces quantitative easing and keeps interest rates low. It is as if the FED were fueling the economy by driving on a patch of ice. Most would expect the Fed to proceed with caution, but instead they go bankrupt. So whenever we see bad numbers, the markets respond positively, and bad news is good news. We have seen this since the market collapse in March 2020 and it has continued. The problem is, we are creating another bubble and when this one finally bursts, we will have to go fast and furious. No one knows when it will be – next week, next month, or a year from now. All we can do as traders is to be careful and execute trades with defined risk.
Take a look at the most recent recession in 2020 – where we saw the VIX climb to 85. At this price, the market expects extreme risk. Ultimately, the VIX is the industry standard for helping traders and investors get a standardized view of market risk through implied volatility.
The VIX is useful because it can give us an idea of what the market is expecting since it is an example of implied volatility. Typically, IV is derived using an options pricing model, such as Black-Scholes. Using these models, the theoretical value of an option can guide us towards measuring the implied volatility at a given point in time.
Traders and investors can use IV to find interesting option trades to hedge, enter or exit a position, or to speculate on a future outcome in the market.
Although the VIX is a measure of implied volatility, there are many historical measures of volatility that can be useful. A common example is the beta coefficient. It is a historical calculation measured by taking the returns associated with a security and comparing the market price action over the same time period. A security with a beta of less than 1 implies that the security is theoretically less volatile than the market as a whole. A stock with a beta greater than 1 would be more volatile than the market.
For those who want to get a full picture of a security’s risk, the beta can help separate market risk from individual safety risk. These types of metrics can help you diversify well based on your individual risk tolerance.
A calculation of historical volatility like beta gives you a basic understanding of what the price of a security has done in the past. While past performance is no guarantee of future results, historical volatility calculations can be used to help measure risk and ultimately help determine if a security is right for you.
THE VOLATILITY OF VOLATILITY – VVIX
To further confuse new traders, there is such a thing called Volatility Volatility or AKA the VIX of the VIX (VVIX). No this is not an exercise on double language if you are a subscriber you would have seen me talk about it before. VVIX is simply a measure of the change in volatility of the VIX Volatility Index. The VVIX is the VIX of the VIX just as the VIX is the VIX of stocks. Okay, if you’re not completely confused now, congratulations, because this stuff can get pretty confusing. Another way to put it is that the VVIX measures how quickly the volatility of the S&P 500 changes, and therefore is a measure of the volatility of the index. Investors can use VVIX and its derivatives to hedge against fluctuations in volatility on changes in the VIX options market. You can cover the hedge!
WHY YOU SHOULD NOT BE AFRAID OF VOLATILITY
All in all, volatility is just one metric that can give you an idea of a security’s potential risk. It’s important to remember that actual volatility is almost always less than implied volatility. No measure of risk will be completely precise, anything can happen in the financial markets. Even so, volatility metrics can provide a clear picture of the risk the market expects.
Have a wonderful weekend!
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