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Volatility Update: Fed Policy Decision Likely to Test Low VIX

October 22, 2015
Smoldering uncertainty as the Fed deliberates

It was about one year ago, on October 15, 2014, that stocks suffered steep losses and the CBOE Volatility Index (VIX) spiked to its highest level in years. Although 12 months have passed, there’s been little change to the primary catalysts that drove the markets then—and now.

Murky Federal Reserve policy is chief among those catalysts, and that sets up an interesting stock market scenario heading into next week’s Fed monetary policy announcement (due for release on October 28). It’s a meeting that just a few months ago was seen by Street economists as all but a lock to deliver an interest rate hike. The Fed was presumed to have already launched a stimulus-cooling campaign to keep the U.S. economy on track by the time October rolled around. Well, it’s not such a sure thing anymore. Federal funds futures market pricing tags March for the first rate hike since 2006.

But does uncertainty persist? Yep, just like it did a year ago. Just for reference, the S&P 500 (SPX) was north of 2000 in mid-September 2014—not too far from its current levels. That was before it suffered a one-month, 7% skid that sent the broad-based index below 1900 through mid-October 2014. Over the course of those few turbulent weeks, the VIX, which had been probing the lower end of the 2014 range near 12, rallied to a two-year high of 31.06 on October 15 (figure 1).

VIX two-year chart

FIGURE 1: HISTORY REPEATING? This two-year view of the CBOE Volatility Index (VIX) compares October 2014 to this October. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Volatility at that time was blamed on everything from Ebola fears, to concerns about the global economy stemming from softening Chinese economic data, to uncertainty about Federal Reserve policy. Sound familiar?

Too Calm?

Yet judging by the difference between VIX today and 12 months ago, risk perceptions have eased notably. Recall that the index tracks the implied volatility priced into short-term SPX options. VIX tends to spike during times of market uncertainty. It closed at 26.57 on October 15, 2014. Fast-forward one year, and the index is near 17. The table below shows that, with the exception of oil volatility (OVX) and eurocurrency volatility (EVZ), most VIX-like indicators are substantially lower today than one year ago.

S&P 500 Volatility
NASDAQ 100 Volatility
Dow Volatility
Russell Small-Cap Volatility
Oil Volatility
Gold Volatility
Emerging Markets Volatility
Brazil Volatility
Eurocurrency Volatility
*Through midday 10/15/15

Although the 26.57 reading from VIX in October last year might seem like a blip compared to the rally above 50 in August 2015, it nonetheless marks a relatively extreme reading. In addition, many of the factors that sent the index higher then are still in play today. Concerns about spreading Ebola may have been immunized, but recent economic data from overseas continues to paint a mixed picture.

On the domestic economic front, signs of economic weakness in jobs, inflation, and retail sales data might have instilled a sense that officials are likely to maintain a zero-rate policy through year-end. That, in turn, seems to be a major driver behind the October stock rally and the recent drop in volatility indexes. However, the Fed has stated that their goal is to “normalize” interest rate policy over time, so future rate hikes should not be dismissed entirely.

Suffice it to say, the factors that rattled markets one year ago are still around today. This choppy and directionless action could very well continue until there is better clarity about the global economy and central bank interest rate policy. For that reason, the Fed’s forward-looking statements could have important implications for VIX and other market volatility measures.

Tom White’s RED Option Strategy of the Week: Think Defined-Risk

Editor's Note: As of October 3, 2016, RED Option is now TradeWise.

A Fed guessing game with plenty of earnings uncertainty tossed in emphasizes the potential effectiveness of risk-defined option trading.

Option premium is rising in individual stocks as event risk is present. Now, we all have different risk tolerance levels; some traders may engage in riskier positions than others. At RED Option, we only trade strategies that we consider “risk-defined.” That means you can calculate your potential downside risk when initiating the trade (minus transaction costs). Okay, so your downside is defined, but guess what? That means sometimes your potential profit is capped, too. That’s the trade-off. Sure, I’d like to increase my profitability, or upside, on a trade, but not necessarily at the expense of worry, portfolio implosion, or money flying out of my account. I might instead decide to stay risk-defined and be comfortable with the potential downside.

I’ve seen it too many times in my trading career—from the CBOE pits, to “expert” recommendations, to retail clients swinging for the fences. They make undefined risk trades that, yes, sometimes deliver. But in some cases, all it takes is one short strangle when the stock moves two or three standard deviations instead of less than one standard deviation. Um, yeah, not the intention of the strangle holder. This sends the stock up 10, 15, or even 20% after earnings, and it’s a painful lesson.

You might think of it this way: try for singles and doubles, or even take a walk. You’ll get another at bat at some point. If you swing for the fences every time—and miss a lot—you’ll be out of baseball, and trading, pretty quickly.

You might instead brush up on risk-defined strategies that include verticals, iron condors, long calendars, and more as the way to go into uncertainty. You can still take advantage of the increased volatility in an individual stock and initiate trades that mesh with your outlook for the shares. High probabilities and increased option premium provide potential opportunities heading into an earnings announcement, for instance. And what if you’re wrong, or the shares have a one-off move against you? Well, at least you know your downside limit and can look forward to coming up to bat again.

Spreads, iron condors, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

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