If the equity markets are being characterized by something at the moment, as a result of the effects of the coronavirus, it is because of their extreme volatility. To the point that one trading session, the indices can appreciate by 4% to leave the same the next day. In this way, it is very complex to operate for small and medium investors, especially if they want to target somewhat longer terms. Without a defined trend in the stock markets around the world, except in the shortest term and therefore aimed at trading operations that require different mechanics in their movements.
Within this very complicated panorama that the equity markets present at the moment, it is the occasion to look at what volatility in the financial markets really is. Because this investment strategy is defined in the percentage and is calculated as the deviation registered by an asset (shares, funds, etc.) with respect to the average of its historical price in a given period. With a very notable difference in a trading session between its maximum and minimum price and that goes beyond the usual in these cases.
To operate in the stock market with volatility, there is no doubt that one must have a greater learning in this kind of operations. Not every investor can open positions in a scenario of these characteristics because he can lose a lot of money along the way in each of the operations. It is rather, on the contrary, that it requires very clear skills on the part of users in the stock market to try to make profitable their available capital in those very special moments that the equity markets offer. Where, and to understand us better, anything can happen with that margin of deviation in the prices of financial assets.
Stock market volatility: the reasons
The result of the last University of Michigan sentiment survey Astounding, the percentage of respondents who see a promising future for their wealth within 5 years has reached new all-time highs. The impact on sentiment of the Fed's massive bailout campaign appears to be succeeding in terms of its ability to convince (the less informed).
The Spanish selective is one of the weakest indices of the large economies, the ones that have recovered the least in the post-crash-COVID rally and the ones that have lost the most in recent days. It is true that you have reached the initial target level for the drop and can now take the uptrend to little help from the equity markets in the world. On the contrary, if sales intensify, it will be essential to closely monitor the support references, if it drills them at closing prices it would open a really worrying and dark scenario for the medium and long term.
Why invest in volatility?
Having a good understanding of what volatility is and how volatility instruments behave is crucial to successfully navigate and invest in the growing volatility landscape. Alternative assets such as volatility can offer investors an important source of investment diversification, help increase the performance of a portfolio, and offer a low correlation with traditional assets.
What is volatility? First, let's understand what people mean when it comes to volatility.
Realized Volatility
Realized volatility is a measure of historical volatility. This is the volatility that actually occurred in the past, but the calculation is time-frame dependent, which can be confusing. For example, realized volatility could refer to daily returns for the last ten days, monthly returns for the last year, or even annual returns for the last ten years. Traders often cite an annualized thirty-day realized volatility.
Implied volatility
Implied volatility is the options market's expectation of volatility over a period in the future, generally expressed in annualized terms. While realized volatility is determined from historical price returns, implied volatility is prospective and is calculated from option prices. This is the measure of volatility that underlies the VIX Index, as well as the measure that people look to trade.
What is the VIX?
The VIX index is the most popular measure of implied volatility. Specifically, the implied volatility in a portfolio of S&P 500 30-day index options. Often referred to as the "fear index" or simply "the VIX," the index represents the market's expectation of stock volatility. While the VIX index itself is not tradable, index futures give investors and hedgers imperfect exposure to the index. VIX futures represent the best collective guess in the market about the value of the VIX index at maturity.
Where do the returns come from? The benefits of investing in volatility come from two separate but related sources:
Volatility Risk Premium (VRP)
The volatility risk premium is the premium paid by hedgers over realized volatility for S&P 500 index options. The premium is derived from the hedgers who pay to insure their portfolios, and is manifested in the difference between the price at which the options are sold (implied volatility) and the volatility that the S&P 500 eventually realizes (realized volatility).
Futures Risk Premium (FRP)
The VIX futures risk premium is the additional premium that hedgers pay for VIX futures over the VIX index itself. This premium is often referred to as "spot", and can be seen in the trend of longer dated VIX futures to trade at a premium to the VIX Index.
Investing in volatility is how to sell more insurance. Investing in volatility should not be confused with volatility hedging. Just like you pay insurance premiums to protect your home from damage, market participants pay volatility premiums to protect against a market crash. Like insurance companies, volatility investors can consistently reap this premium.
It is important to remember that insurance companies also make payments after adverse events, and investors in the volatility arena can experience similar declines during volatility peaks. For this reason, investing in volatility should only be viewed from a long-term perspective and as a diversification into traditional portfolios. Like insurance companies, volatility investors take short-term risk to reap the long-term risk premium.
Manage risk
As the name suggests, volatility returns can be volatile in times of market turmoil, and proper risk management is critical to investing success. Along with intense analytical and technical analysis, here are some key points to keep in mind:
Keep a long-term perspective
Investing in volatility is not a get-rich-quick scheme. It is an asset class that offers an intriguing risk and return profile. Like any asset class, it should be carefully placed in your asset allocation and outsourced to professionals if you are not constantly monitoring it.
Diversify properly
In addition to diversified asset allocation, diversifying your volatility investment through term structures, volatility products, volatility strategies, and geographies can help smooth returns and improve your risk-adjusted readjustments.
Be proactive
To keep the volatility risk premium and the futures risk premium in your favor, it is imperative to remain systematic, properly scale your exposure, and be willing to switch to cash frequently and often.
The global outbreak of COVID-19 has sent global stock markets into chaos. With massive declines followed by huge bounces day after day, volatility has become an ever-present force that investors have to manage.
Many investors are looking for ways to turn volatility into profit. The CBOE Volatility Index, also known as VIX, has become a key measure of how panic some investors are feeling, but investors are also using the benchmark more actively as part of their overall investment strategies. Next, we will see more about the VIX and why you should understand the role it can play in your portfolio.
Trading the VIX
The CBOE Volatility Index examines options markets to determine how much volatility market participants expect in the near future. By looking at the different options and their prices, he is able to calculate a number that investors are implicitly using to guide their option trading. The higher the number, the more volatility investors expect.
However, you don't have to be an options trader to get valuable information from the VIX. Some investors call the VIX the Fear Index, because it tends to rise during downturns in markets and lower at better times for the stock market.
Forms of investment in the VIX
Additionally, investors have found ways to make money directly from movements in the CBOE Volatility Index. The publicly traded iPath S&P 500 VIX Short-Term Futures seeks to track the VIX by entering into futures contracts tied to the volatility benchmark, and from February 20 to March 13, it has more than tripled .
If you are aggressive and like risky plays, you can get more exposure to the VIX. The ProShares Ultra VIX Short-Term Futures has more than quintupled over the same period, because it has a share price that seeks to provide a leveraged exposure of 1,5 times the movement in VIX futures.
What every volatility investor should be aware of as unfortunately, there are many dangers when investing in volatility. They include:
Being on the wrong side of volatility trading can be devastating to your portfolio. For example, ProShares Short VIX Short-term Futures is designed to move higher when the VIX moves lower. It has lost more than half its value between February 20 and March 13, and it could see even bigger losses if volatility spikes further.
Volatility investments are designed to be short-term, with returns tied to daily changes in the VIX. For long periods of time, owning investments tied to volatility has been a terrible gamble. The product of iPath volatility, for example, lost money every year from 2009 to 2017, posted a small gain in 2018, and then plummeted by two-thirds in 2019.
Due to their design, both long and short volatility investments may lose value over time. Big swings can move in any direction, and they can be fast and furious. In early 2018, all it took was a single day of increased volatility to end a short volatility leveraged fund.
Is it worth the risk?
All of these risks are hard to see when the prices of volatility-linked investments skyrocket day after day. However, as with many stocks and ETFs that become popular for a short period of time before returning to earth, investing in volatility tends to bring long periods of losses punctuated by only occasional bursts of glory as we have seen recently. .
At this time, many of the volatility gains from ETFs have already been factored into their prices. Volatility could continue to increase. However, when markets calm down, volatility investors will find out the hard way how quickly their investments can reverse downward, even when high-quality stocks are proving their long-term value.
The name VIX is an abbreviation for "volatility index." Its actual calculation is complicated, but the basic objective is to measure how much volatility investors expect to see in the S&P 500 Index in the next 30 days, based on the prices of the S&P 500 Index options. Stocks Calm, VIX Low; When they expect big changes in the market, the VIX goes up.
In times of great market turmoil, the VIX has tended to rise. The graph above shows that the VIX index rose steadily as the market approached the peak of the tech bubble of the late 1990s, calmed down during the steady growth period of 2003-2007, skyrocketed during the credit crisis of 2008 and in the second half of 2011, and recorded increases in early and late 2018. Due to this pattern of behavior, the VIX is sometimes known as the "fear index" - when market participants are concerned about the market, the VIX tends to rise.
Volatility is a performance driver that is not dependent on interest rates, dividends, or price appreciation, making it particularly attractive to investors looking for other sources of return.
Volatility products have a strong negative correlation with equities and therefore add value as portfolio diversifiers. That negative correlation of equity volatility doesn't just apply to equity markets, as similar patterns can be found in the credit market. Spikes in credit spreads often coincide with increases in equity volatility.
In addition to being a portfolio diversifier, volatility can protect against certain risks. For example, an investor who owns a stock or a futures index that could be affected very positively or very negatively by an upcoming announcement can keep the stock or futures and hedge the risk with volatility.
As well described in the literature, traditional diversifiers offer fewer opportunities for diversification during a financial crisis. Equity volatility, represented by the VIX, can serve as a natural diversifier, as its negative correlation with equities and other asset classes increases during the crisis period. VIX Futures provide diversification benefits exactly when they are needed most. As you can easily see below, volatility trading can be extremely rewarding. Also, historically, we can find that strategies that invest in volatility have generated higher returns with lower losses compared to traditional equity portfolios.