"You can never plan the future by the past." -Edmund Burke
Volatility has received considerable attention over the past week, as a pre-market VIX spike to $65 captivated normally complacent market participants. Was it an imminent depression? Was it a repeat of the Great Financial Crisis? Was it because Kamala Harris took the lead in the polls? Obviously not, friends. It was none of these. It was a trick of liquidity dynamics and massive ask/bid spreads. It was a strange convergence of the unwinding carry trade, Wall Street being on vacation, and complacent short volatility trades.
What it was decidedly not was the beginning of a bear market. If it were, I highly doubt that the curve would have so rapidly normalized. Indeed, after one of the largest VIX spikes in history, we experienced one of the largest VIX crushes in history. As you can see above, the curve has rapidly flattened.
There is a lot of magical thinking in markets, but you must remember that the price of mainstream assets is set by billions or trillions of unrelated decisions. There are thousands of different reasons to buy or sell an asset. There certainly are catalysts that cause simultaneous collective behavior (in either direction) to spike, but they are rare. As Mr. Burke's opening quote suggests, assumptions based on the past are hazardous.
Yes, oil could spike from an Arab-Iranian confrontation, but the energy intensity of the US economy is so much lower that it would take quite a spike to hurt the US consumer in a major way. The economy of today is nothing like the economy of the 1970s and 1980s. Given the rapid pace of technological and economic change, it might as well be the economy of the 1870s for our purposes.
The biggest risk facing markets right now is probably what many consider an imminent likelihood of an Iranian attack on Israel. While this is a scary catalyst that might cause oil to spike, I think it is unlikely to significantly interrupt economic activity in a way that will seriously vex the market. The Middle East economy is more fragmented and insulated from war than in the past. A significant percentage of global oil production is not threatened. As I stated in a previous article:
The macroeconomic impact of the Arab-Israeli conflict, particularly in the wake of the Yom Kippur War, was multiplied by two factors: The Cold War magnifying and intensifying the consequences of the conflict and the developed world's dependence on foreign-produced oil. Both of these items have changed. The world is still far more globalized now than it was then, despite recent and apparent setbacks to globalization. The first significant change is that the US economy has become far less reliant on oil and is far more efficient in its use than when the Arab-Oil Embargo roiled global markets and the US economy in particular." -Me
Volatility around the Israeli-Iranian conflict has so far been pretty disappointing. This time could be different, but if we strictly use recent historical precedent as our guiding pole, I don't think either side finds an extended hot war desirable or sustainable. The geographic separation is ill-suited to both Iran's and Israel's military capabilities. In any event, the economic fragmentation of the Middle East suggests that the actual economic impacts of such a conflict will be muted, even in a worst-case scenario.
Shorting Wars and Elections Because of a Strong Economy and Earnings
You can also see that election volatility is elevated now, which is usually the case when heading to elections, given the uncertainty about future administration and its direct bearing on regulations, taxes, and corporate earnings. This economy has been defying recession predictions for quite some time, and I don't think the current data suggests the bottom will suddenly fall out of the tub.
Last week, we recommended a short volatility trade here at Punk Rock Traders. I postulated that I thought the true mean of the VIX was lower than last Tuesday's and recommended that you purchase November 20, $23 put options on the CBOE volatility index. They are up 23% since. Those options are up 23% as of yesterday's close. As I said last Tuesday, when fear was very much still in the air:
"The guard rails are still on the economy and the market, and that favors volatility to hang out in the low twenties or high teens instead of reverting toward the highs experienced Monday." -Me (last Tuesday)
As you can see above, what I postulated last Tuesday has come to fruition. The VIX is hanging out in the low twenties and high teens and made an intraday low yesterday in the $18 handle. I wanted to capture what I believe will be a protracted but steady retreat from the volatility highs of last Monday.
I am confident in declining volatility because of the fundamental strength of the economy, the persistent decline of inflation, which I believe will be validated tomorrow, and the general resilience of American corporate entities in terms of their earning power in the wake of COVID-19.
Another factor that gives me confidence in a lack of volatility is the typical post-election volatility election crush. The implied volatility of options contracts is generally higher than realized volatility. This doesn't mean you should always sell options for a premium, but it is an observed relationship.
However, I do think it is appropriate to be short election volatility. Even in an unsettled election where the incumbent President baselessly declared he won against all evidence, it did not rob us of the post-election volatility crush in 2020. As you can see above, in one of Europe's most uncertain elections in years, a post-election implied volatility crush was also experienced.
Many volatility models rely on pricing data. Most of these are largely agnostic about fundamental and qualitative insights. However, I use fundamental and qualitative insights as my primary tools and then use quantitative ones to support them. There is no reason why volatility forecasting using fundamental data, paired with astute qualitative analysis, can't beat number dummies pushing models using only pricing data. I dare you to challenge me on that. Here's the thing: The economic data is strong, and Technology is due for a major comeback.
The market tends to overestimate the volatility of large companies and companies with high returns on assets. I think the market is dramatically overestimating the downside potential for Technology right now, and I think both Fed cuts and Nvidia earnings will help boost some of the Tech that sagged on poor guidance. It's important to remember that these are the strongest commercial entities in history; the market actually held up pretty well when they tanked in recent volatility.
The market tends to underestimate volatility when there is a high degree of volatility with cash flow. However, the robust post-COVID corporate entities have been generating cash flow in quite a stable and prosperous fashion. This is another fundamental underpinning of my trade: to continue shorting volatility.
I think it is very unlikely that we get another volatility spike on the scale of last Monday anytime soon. Part of this is that Monday was largely a "head fake." I think the theoretical true volatility number was much lower than the headline $65 reading, and the rapid collapse of the curve suggests that a new catalyst is necessary to cause a volatility spike. I think it is unlikely that Iran and Israel will be a major market-moving catalyst despite the seriousness of the situation. Therefore, I'm doubling down on my volatility short going into November and adding a lower strike price for those who missed the initial drop.
In this particular case, these contracts are meant to be held to expiration. They are specifically playing the post-election volatility crush that typically happens once an uncertain event passes without causing a major disaster. Even if volatility spikes because of an Iranian attack, the time value on these contracts going out into late November should insulate you from any immediate effects. The VIX will be below $18 on November 20th, 2024.
Buy $18 VIX puts at the November 20th Expiration. The last price was $2.27.
The $23 November 20th puts I recommended are already up around 28% at the open. If you have already entered this position, you can add these to it.
These contracts are meant to be held to expiration and print-in-the-money.
