Market volatility has been historically low of late. But that’s looking more and more like a mirage. I’ll expand on that in a bit. First, I want to tell you a remarkable story about the power of patience—and not just with investing...
Three years ago, I got a call from my friend’s wife at 6 am. She was hysterical, and told me that my best friend Chris had suffered a massive heart attack and she wasn’t sure he was going to survive. I immediately jumped on a plane and spent the next week with Chris and his wife.
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Chris, who was 36 at the time, was in great shape and had suffered a massive heart attack while on an early morning run. A stranger found him and called 911. On the way to the hospital, his heart stopped twice but the paramedics were able to bring him back to life.
At the hospital later that day, we were told that things were not looking good; best case, Chris would survive but be unable to speak or care for himself ever again. At that time, Chris and his wife had one baby with another on the way, and they were closing on a new house that week. It was heartbreaking.
However, each day, slowly but surely, the prognosis improved. Fast forward to today, and Chris is nearly 100% recovered.
Two weeks ago, my wife and I traveled back to Chicago to celebrate his third “anniversary.” On the back of the bottle of wine that we drank that night celebrating was a quote from Ralph Waldo Emerson, that fits life, as well as trading.
“Adopt the pace of nature: Her secret is patience.”
The next day, with the Nasdaq down 1.3% and many former leaders falling, this quote fit perfectly for the trades that I was seeing in the options market.
Market Volatility ‘Artificially Low’
As I noted to Cabot Options Trader subscribers as we headed into the Nasdaq swoon, traders had been buying call options on growth stocks expiring in the fall of this year and into next year—a strategy that’s similar to my trading. I know that no trader is good enough to buy the bottom and sell the top consistently, so I buy calls/puts with time, so that the occasional market instability won’t shake me out of a position I like.
For example, the position in our portfolio I like best right now is our Cypress Semiconductor (CY) calls. The large daily call buying targeting September and beyond is exactly the action I like to see. The big trader I’m watching is buying more and more calls, and he’s putting more and more capital into his trades. Recently, CY has pulled back with the Nasdaq and our position is currently at a loss—but because we own September calls, we can be patient.
Of course, there’s always the potential for a much bigger market fall, which would almost certainly cause our CY trade to fail. And with the Chicago Board of Options Exchange Volatility Index (VIX), which is often referred to as the “fear index,” near all-time lows, complacency is running high.
‘When This Goes, You’re Going to See the Mushroom Cloud from Saturn’
“[The Fed] is not adding to market stability. They’re just building a bigger bomb,” said Tom Chadwick, a New Hampshire financial adviser who uses VIX options to help protect his clients’ portfolios from downturns. He says the Fed’s policies have kept market volatility artificially low for so long that the speed of any reversal will be severe. “When this goes, you’re going to see the mushroom cloud from Saturn.”
Chadwick’s quote is from a Wall Street Journal article two weeks ago that mostly noted how prevalent selling market volatility/insurance has become. Everyone from beginner traders to sophisticated pension funds has incorporated this strategy into their trading as a way to create yield. And the insurance selling has paid off nicely, as the market has had few significant pullbacks for years.
However, I couldn’t agree more with Mr. Chadwick. At some point, an event will cause the VIX to make a move the likes of which we have never seen before. Why is that my belief? Because now more than ever, traders and investors are shorting the VIX and volatility. This wasn’t nearly as popular a strategy in 2008/2009 when the VIX shot to 80 during the financial crisis. But now, with the added fuel of traders needing to cover shorts if the VIX screams higher, there’s the potential for an unprecedented move in terms of speed and price.
That said, I’m not advocating buying calls on the VIX or VIX futures. These are incredibly difficult products to trade. For example, if you buy July VIX calls and the VIX goes higher, there’s no guarantee that your calls will be profitable (my old trading firm hired a team of 10 quants/mathematicians to figure out the VIX and could never fully grasp some of its quirks).
Also, the ability to time a market fall or a VIX surge is extremely challenging. A 1% to 3% fall in the S&P 500 is not going to cause a significant jump in the VIX. More likely, it would require a fall of 5% to 10%. And guessing when such a big move is likely to occur is nearly impossible.
So if the VIX explodes higher and the market crashes, we will take a loss on our CY calls. However, until I see more than a 1% to 3% drop in the S&P 500 and Nasdaq, I’ll take Emerson’s advice and remain patient with my bullish positions.
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