[The post was drafted in September 2017.]
Trader Smith: “S&P 500 is too expensive; VIX is too low. Hence VIX is to go up big time and am going to long VIX/buy options.”
- Historically low VIX is a reason (another one being high equity valuation) often cited to suggest market complacency and the need to long VIX, expecting volatility to go up. Indeed, VIX might seem low relative to the uncertainties facing the world, Brexit, North Korea nuclear threat, Trump, just to name a few.
- However, (market) risk is not directly comparable to uncertainty. Low risk can sustain amid high uncertainty. It is vitally important to differentiate between market risks – which are trade-able a.k.a “known unknown” – and uncertainties which are often un-trade-able a.k.a “unknown unknown”.
- Market implication: One should not long VIX simply because he believes that VIX currently looks low relatively to uncertainties. From asset allocation perspectives, relatively low VIX does not necessarily lead to the conclusion of reducing portfolio risks by selling equity and/or overweight gold and safe-haven currencies such as JPY and CHF.
Investors expecting VIX to jump to a substantially higher level usually cite two reasons: the US equity looks very expensive and the VIX currently seems very low relative to the uncertainties we are facing. And they usually like to blend the two reasons together.
However, those are two distinctly different argument. Each of them would open up a large and controversial debate. I will leave the valuation debate for now – there are points arguing for expensive US equity vs those arguing that US equity is fairly valued – and instead focus on the second reason: VIX looks very low relative to the uncertainties we are facing.
In general, the market knows how to trade risks. Uncertainty cannot be traded/insured against. Politics is a prime example that creates uncertainty, not risks; it is hard to put probability distribution towards politics. And political uncertainty is new to developed market, the anchor of pricing for the whole markets (including EMs).
Therefore, market participants often ignore uncertainty and take “wait and see” mode; i.e. react to uncertainty as the events unfold and take investment decisions only when the uncertainty declines. And materialization of uncertainty often leads to market disruption and jumps in volatility.
There are a few things we could do amid low risk and high uncertainty:
- Worse case scenario planning and decision tree planning, so that one won’t panic when a negative outcome materializes.
- Track the events as new information comes out to reevaluate outcomes.
- Hold cash to trade out of events, rather than trade the events.
- Differentiate between geopolitical risks that fade away easily versus political risks that have material economic impact.
liyufeili 