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Betting against Volatility: Worth the Risk?

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Risks with insufficient prospective return potential (Continued…..)

Short volatility strategies: There has been considerable commentary recently about the low levels of volatility observed across markets, particularly the equity market as measured by the CBOE Volatility Index (VIX). At these levels, betting against a future rise in volatility has become a bit like picking up pennies in front of the proverbial steamroller; it works for a while but is not worth the risk.

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US stock market surged amid low volatility

The US stock market rallied after the November 8 presidential elections. Investors flocked towards the stock market on expectations of Trump-induced policy implementations like tax reforms, lighter regulatory reforms, higher infrastructural spending, and a shift from fiscal to monetary policy.

The stock market rally continued in 2017 as investors seem more confident about the economy, rising corporate earnings, declining unemployment rates, and more Fed rate hikes. As per Factset data as of May 19, the S&P 500 Index’s earnings growth for 1Q17 is 13.9%, the highest earnings growth since 3Q11. Around 75% of S&P 500 companies surpassed their earnings per share estimates for 1Q17.

The S&P 500 Index (SPY) (SPX-Index) has risen 8% so far in 2017. The stock market rally seems to be largely driven by an upbeat outlook for US corporate earnings growth in 2Q17. As per a Factset report on June 30, 2017, the estimated earnings growth rate for the S&P 500 is 6.6% for 2Q17.

What drives market volatility?

The CBOE Volatility Index (VIX) measures the volatility in the US stock market as represented by the S&P 500 Index (SPY) (SPX-Index). In other words, it measures the market’s blood pressure, so market reactions usually drive the Volatility Index. Geopolitical crisis, market expansions, the Fed’s decisions, and politics are some of the factors that drive volatility.

Despite uncertainty, the lack of clarity in President Trump’s policies, and the situation in Europe, the index is currently trading at low levels, as the chart above shows. The index hitting its lows also led to lower volumes, while the S&P 500 surged amid low volatility. As of June 30, 2017, the index has fallen 20%, while the S&P 500 has surged 8% year-to-date.

The US stock market continues to rise higher amid lower volatility and volumes. Investors need to be cautious about whether it’s worth the risk to bet against volatility in the current scenario. Low-volatility indexed ETFs like the PowerShares S&P 500 Low Volatility Portfolio (SPLV), the PowerShares S&P MidCap Low Volatility Portfolio ETF (XMLV), the iShares Edge MSCI Minimum Volatility USA ETF (USMV), and the iShares Edge MSCI Min Vol EAFE ETF (EFAV) could be good options to consider.

Let’s move on to discuss whether small caps could be rewarding.

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