Cold Turkey. Yesterday, speculative traders gave up on the dip buying strategy, cold turkey, as stocks sold off leaving both the Dow and S&P in the red for the year. Markets started the day on their heels, still reeling from Monday’s tech rout, when a spate of disappointing retail earnings hit the tape, and Boeing made a PR misstep causing all of the major indexes to sell off. Oh, let’s not forget the fact that crude oil continued its slide, making new lows, putting even more pressure on stocks. On a week that is typically characterized by low volume, traders were taken by surprise on an above average volume day. The selloff in the retail sector was less about the earnings and more about the outlook as Target (TGT) posted the only miss yesterday morning with a -2.8% negative surprise. A common theme from the retail earnings commentary was: expected headwinds and margin pressure from rises in labor costs, logistics cost increases, and the trade war. Not exactly what investors want to hear. Additionally investors continue to worry about interest rates and what the Federal Reserve might do at their next policy meeting, just weeks away. There is still a 72.3% chance of a 25 basis point hike at that meeting and with the housing sector starting to show signs of a slowdown, many folks are jawboning the Fed into slowing down the hikes. In fact, just yesterday the President himself called for the Fed to cut interest rates. Wow.
Housing and Real Estate is particularly sensitive to interest rates as both developers and buyers (and Presidents who were formerly real estate developers) are so highly reliant on debt finance. The net result of all of the unknowns has been a ratcheting up of market volatility in the past several weeks, which can be seen in the VIX index (chart 5 in my attached daily chartbook). I frequently reference the VIX index and you may be wondering: what is the VIX index, really? Well, today being geek-out Wednesday, I will give you a little more detail on this complex, misunderstood, hash-tagged, and highly-quoted-in-blogs index.
The concept of the Volatility Index or VIX was created and first proposed by Menachem Brenner and Dan Galai in a 1986 academic paper, which was ultimately published in the Financial Analyst Journal in 1989.
If you are pressed for time or don’t feel like falling asleep at your desk, I will give you the highlights. The index, originally called the Sigma Index, was formulated to provide expectations for future volatility in the stock market. In 1993 the first VIX futures were traded on the CBOE and was called the VXO and went through several iterations before the VIX index we know and love today began trading in 2004, with options added in 2006. Glasses on. Volatility is a measure of a stock’s price variability over time. If we look at the price history of any financial instrument and calculate daily change, we can use that time series to calculate average daily change (mean), variance, and standard deviation. The standard deviation shows how much the daily change can deviate from the mean. Therefore, a higher standard deviation means that a stock is more volatile. A more volatile stock is more likely to surprise investors on both the upside and the downside. Standard deviation is a statistical measurement, which has been, and remains, a mainstay for quantitative analysts and traders. The problem with Standard Deviation is that it relies on historical data, which may not be an accurate predictor of future volatility. For example, a stock can display low historical volatility but changes in the stock’s fundamentals, news, macro factors, or overall market volatility can change the picture drastically. The VIX index uses a different methodology in order to attempt to provide a more accurate measure of future volatility. The VIX relies on options pricing theory in its calculations. I am going to overly simplify it here but my description should give you a good idea of how it works.
Options prices are based on five primary inputs: price of the underlying stock, strike price of the option, time until the option expires, risk free interest rate, and volatility. Exchange traded options prices are readily available and are based on supply and demand. So if many traders believe that a stock will be going up they will demand call options thus bidding up the prices of calls. If we know the option price, the time until expiration, the strike price, the underlying stock price, and the risk free rate, we can determine the volatility by solving the equation (in this case the Black Scholes model). What we end up with is referred to as the Implied Volatility, which is considered somewhat more accurate because it takes into account investor expectations of a stocks future value. The VIX index utilizes the implied volatility of put and call options on the S&P500 futures contract (SPX) through a complicated weighting scheme. Technically speaking, the VIX is quoted as a percentage, so if the VIX is trading at 21.51, as it is this morning, it means that the S&P500 is expected to trade within a range of up or down 21.51% over the next year. It is an annualized rate, so if you want to know what will happen over the next month, simply divide the VIX by by the square root of 12 (3.4641) and you end up with and range of up or down 6.21%. If you like pain, you can read about how the index is calculated in detail here:
Cool to know, but the important take away here is that the resulting calculation is an index that goes up when the market is going down as volatility and investor fear increases and vice versa (though they are not perfectly negatively correlated).
The behavior of the index makes it a good hedging tool as it can provide diversification to a stock portfolio. The index itself cannot be traded, but futures, futures options, ETN’s (exchange traded notes), and ETN options are available to qualified investors. The easiest way for you to track the VIX is by using the symbol VXX, which is the Barclays iPath S&P500 Short Term Future ETN. Caveat emptor: simply placing a VIX future, option, or ETF in a stock portfolio will certainly lessen the overall volatility of the portfolio but it will also limit its upside. Additionally, the index, because it is based on human emotion tends to spike when emotions are high making it difficult to trade in and out of in fast moving markets, which is usually when traders are looking to make moves. This is not an instrument that is suitable for most investors, however if you are interested in learning more, you should reach out to your investment advisor. Glasses off.
This morning we got Durable Goods Orders, which fell by greater than expected -4.4% versus last month’s increase of +0.7% which was revised to -0.1%. Later this morning we will get the Leading Index, which is expected to show an increase of +0.1% versus last period’s +0.5%. Also, we will get Existing Home Sales, which is projected to show an increase of +1.0% versus last month’s decline of -3.4%. Any deviation from expectations will certainly impact the markets. Speaking of the markets, overnight buying in the futures markets are pointing to a positive open indicating that the dip buyers may be cueing up for a second helping. Have a Happy Thanksgiving and please call me if you have any questions.