Many people have the mistaken idea that high volatility (VIX) means falling markets. They’ve been trained by financial news outlets to associate volatility with fear. This notion is only half right. Volatility is also connected to greed. In reality, volatility is a reflection of the size of a price movement regardless of the direction. Take a look at the chart below and you’ll see that during the late 1990s price was rising, but in wide daily ranges. This caused VIX to rise substantially while the market was going up. VIX went up from about 10 to 27 (170%) while the S&P 500 index (SPX) almost doubled from late 1995 to just before the Russian financial crisis of 1998. So without much “fear” in the market VIX nearly tripled.
After the Russian financial crisis VIX stayed elevated in a range between roughly 19 and 30 as SPX climbed 38%. Large range days while the market was rising created an elevated VIX. SIDE NOTE: I’m using VIX to show the price move although what is now VXO was the calculation used in the late 90s. But the point is moot since the price movements of VIX and VXO were similar.
Understanding that it’s the range of price, not the direction, that elevates VIX will help you see why products that benefit from volatility make good hedging instruments. As an example, last Friday when my market risk indicator signaled, SPX closed at 1970.69. Mid term volatility (VXZ) closed at 11.01. Today SPX is above last Friday’s close and VXZ is up 15% from that level. The wild swings in SPX during the past week has kept mid term volatility elevated. Volatility begets more volatility as market participants try to react to fast price moments. So on steep market declines volatility comes into the market quickly but leaves it slowly. It is these factors that make mid term volatility a good hedging instrument.
For now, all of the portfolios are aggressively hedged. Here’s how I’m planning on managing the hedge going forward. If the market calms, volatility will come down and I expect my market risk indicator will clear. If that happens I’ll soften the hedge on the core portfolios and remove all hedges from the volatility hedged portfolio. On the other hand if the market falls and retests this week’s lows I’ll sell one third from the aggressive hedges plus all of the profit they’ve generated. I’ll take the profit and buy more longs for the portfolio. The third of the hedge that was sold will be used to buy a short of SPY (or buy SH). Basically, I’ll soften the hedge and rebalance. The reason for this is that I can’t call a bottom so I’ll take profit all the way down and use it to buy stocks I want to hold going forward.