Dave Gonigam

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Bracing for “Extreme Moves”

After a September scare, a calm runs through the markets again. An eerie calm. A calm that can’t last.

The Dow tumbled 200 points yesterday, setting off a minor wave of volatility as measured by the CBOE Volatility Index — the VIX. But it’s still not much in the scheme of last year – or, for that matter, a month ago…

Extreme Moves

“The VIX trades roughly in the range of 0–100,” explains Jim Rickards, “although, as a practical matter, it never reaches either extreme.

“A volatility index level of 80 would be associated with something like the Panic of 2008. An index level of 10 would be associated with an unusually calm period of smooth sailing in financial markets. Most of the time, the index trades between those levels.

“When you trade volatility,” Jim goes on, “you are not betting on the direction of markets — you are betting on whether or not extreme moves are in store.

“Those extreme moves could be up or down for a variety of market measures. When you have a ‘long’ position in volatility, you don’t care if a certain market goes up or down, you just care that markets are jumpy and moving in some unexpected or extreme way.

“When markets are already nervous, the price of volatility (reflected in the index level) skyrockets. The way to profit is to buy volatility when it’s cheap and then reap rewards when volatility suddenly skyrockets due to the occurrence of a market or political shock.”

Which is what the market is teeing up right now: Jim calls it “one of the most compelling investment opportunities we’ve ever come across.”

The VIX sits at low levels “in a world waiting to explode with volatility due to unstable currency exchange rates, bank liquidity crises, geopolitical uncertainty and a wild U.S. election cycle.

“One or more of these potential sources of instability are ready to pop up on the markets like a tightly jammed jack-in-the-box when someone unlocks the lid. The key to profits is to understand how to use volatility as a trading strategy. If you act now, you could reap huge rewards in a matter of weeks.”

With that in mind, let’s examine the chart above in a little more depth.

Yesterday’s bump up in volatility has stretched into today, and the VIX rests near 16. That’s still 11% lower than the most recent peak a month ago.

“That mid-September peak,” Jim reminds us, “was associated with market uncertainty involving Deutsche Bank liquidity problems; the Clinton health scare of Sept. 11; uncertainty in the run-up to the Fed meeting on Sept. 21; and a Trump surge prior to the first presidential debate, on Sept. 26.”

But even that spike last month is child’s play compared with other episodes in recent market history, Jim points out…

  • “The volatility index hit 79 on Oct. 24, 2008, at the height of the panic of 2008 and in the aftermath of the mortgage market collapse, Lehman bankruptcy, AIG bailout and TARP legislation
  • “The volatility index hit 41 on May 7, 2010, and spiked again to 43 on Sept. 20, 2011. Both spikes were in response to the ongoing European sovereign debt crisis that began in early 2010 (following the default of Dubai World in November 2009) and continued in stages (through the last Greek rescue package in 2015)
  • “The volatility index surged to 28 on Aug. 21, 2015, in the wake of the shock Chinese currency devaluation on Aug. 10 and subsequent plunge in U.S. stock prices, which resulted in an 11% correction. That sell-off was only fully alleviated when the Fed postponed its hoped-for September 2015 ‘liftoff’ in interest rates
  • “Finally, the volatility index peaked at 25 on June 24, 2016, in the immediate aftermath of the ‘Brexit’ vote by the U.K. to leave the European Union on June 23. This volatility spike was the last one prior to the recent mid-September spike associated with Deutsche Bank and the Fed meeting.”

Now think for a moment: How likely is it the VIX won’t spike to last June’s levels before the end of the year?

Consider all the turmoil of recent weeks: The “flash crash” in the British pound last Friday. The looming threat to the financial system posed by Deutsche Bank. The election campaign, likely to deliver a few more surprises even if David Stockman is right and Hillary Clinton has it sewn up. And the threat of a new cold war between the United States and Russia turning hot.

The setup in the VIX right now is an “asymmetric” trade — Jim’s favorite kind. “VIX is unlikely to go much lower, because it is already at an unusually low level relative to its longer-term behavior. Conversely, the VIX could easily spike based on one or more new shocks, or shocks from already known problems like Deutsche Bank that are dormant but could re-emerge at any moment.

“In summary, the odds of losing money on a properly constructed volatility trade are low, and the odds of making huge gains are high.”

Regards,

Dave Gonigam
for The 5 Min. Forecast

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