Following the fear: market volatility means opportunities

The Covid-19 outbreak has brought an abrupt halt to one of the longest periods of low market volatility in history. Since central bankers launched their vast stimulus in the wake of the global financial crisis, stock markets have ticked higher, largely uninterrupted. In March, markets experienced their first real volatility in a decade.

This is demonstrated by the performance of the VIX. This index gives the market's expectation of 30-day forward-looking volatility, based on S&P 500 index options. It has become a proxy for market volatility, though it should be said that the S&P 500 has been notably less volatile than other major indices in recent years, so it is an imperfect reflection of global stock markets.

To give an indication of scale, the benchmark VIX index has barely tipped above 30 over the past 10 years and has tended to trade between 10 and 20. In March of this year, it peaked at 83 and has remained elevated ever since, though is now between 30 and 40.

What happens next?

It may be tempting to assume that as the Covid-19 outbreak ebbs and the world’s largest economies get back to some form of normal, market volatility will also return to more normalised levels. Certainly, the VIX is also known as the ‘fear index’, rising as investors become more nervous and falling as they become more complacent. If fear is receding, then, by extension, the VIX should drop as well.

That said, it is clear that the market has a lot of bad news to process and is vulnerable to further outbreaks of the virus. The VIX spiked up again in mid-June on fears of a second wave of Coronavirus cases in Asia and the US. It is likely to be sensitive to the path of the virus for some time.

Central bank support

Much of the benign volatility of recent years can be explained by the support provided by central banks. Central bank policy continues to have a significant influence on market volatility and this has been seen throughout the recent crisis. The spike in volatility seen in March was largely assuaged by central banks stepping in with stimulus packages alongside generous government support. In June, testimony from Federal Reserve chair Jerome Powell revived markets as he indicated central banks would continue to provide support.

As such, those trying to predict the direction for market volatility will need to pay close attention to the guidance emerging from the central banks, particularly the Federal Reserve. Stock markets like loose monetary policy and abundant liquidity.

It is worth remembering that volatility is often a reflection of fear in the market, so looking at the relative optimism and pessimism of investors is another tool. That may be through the level of short selling in the market, investor confidence surveys, fund manager cash levels or media headlines. Government bond spreads can also be an indicator of rising fear in the market. If 10-year treasury yields are falling, it suggests investors are retreating into safe haven investments in response to a perceived threat to stock markets.

As with normal securities, it is possible to trade the VIX in both directions. If investors believe that volatility is likely to fall – perhaps because investors are growing more confident – they can short the VIX using contracts for differences.

Individual securities

While many aspiring volatility traders are only looking to trade aggregate market volatility, it is also possible to trade volatility for individual securities (shares) or commodities. This can be more rewarding as volatility is usually far higher in, say, the price of oil or an individual company.

Investors can use contracts for difference to take advantage of anticipated price volatility. There are also indices measuring the volatility of individual assets – the CBOE Crude Oil Volatility Index, for example. Again, these can be traded long or short.

While the drivers of the volatility of individual assets will vary considerably, a useful tool in predicting spikes in volatility can be Bollinger Bands. These measure the extent to which an individual security is moving away from its long-term average and can give early signals of a trend.

Volatility trading has been a lot more exciting in recent months with significant moves in stock and commodity prices. Traders may want to take advantage while investors are still fearful. If that’s of interest to you, the Fineco trading platform offers many tools and options for volatility traders and at very competitive prices.