5 Things That Could Go Right: Why Volatility Should Remain Subdued During Summer

If you were allowed one wish for your child, seriously consider wishing him or her optimism. -Daniel Kahneman

Bad news sells better than good news, and prognostications of impending doom are always, on their face, seemingly more urgent to us than the cold and indifferent facts of reality that truly define the world around us. Human beings need a story to attach to what would otherwise be an inexplicable and probably terrifying series of random events without the anesthetizing comfort of the narratives of varying accuracy that we use to explain and order these events.  And we understandably overly focus on risks that could result in our untimely demise, even if there is very little true probability of these grim anomalies occurring. Of course, much of the media makes a lucrative business of encouraging our lesser impulses.

We do the same things in financial markets. The reality is, though, that we live in a world that is largely beyond our control and mostly beyond our understanding. Most of the risks we choose to focus on are no more significant than social preferences, as evidenced by the flurry of inaccurate recession predictions.

Sure, in certain ways, we have come far as a species. However, we are only a couple thousand years removed from barely scraping by on subsistence living, with no current civilizational trappings or creature comforts. And if you think about how long evolution takes to catch up, our bodies are still essentially the same as they were back then. That is, all of us are quite ill-prepared for our new-fangled world in many ways, and that proves even more true when it comes to finance.

Part of the consequences of this, and it makes sense if you think about it, is that we are always watchful, always paranoid of what could lurk around the corner; glowing eyes in the night will send shivers of fear down even the bravest of us. But the reality is now that we have mastered our environment in a lot of ways that make our pre-industrial and pre-civilizational instincts not only a lot less useful in modern life but downright counterproductive in our quest to seek a better risk-adjusted return on our investments than our neighbor and than the benchmark.

One of the easiest ways to do this is to turn your moment of maximum fear and pessimism into your greatest opportunity. If you'll see when the fear index gets inverted, meaning there is an irrational rush to buy downside protection and fear is at or near its highest (Like the 4M-1M inversion in the chart above), this is one of the best times to either buy beaten-up assets, short the VIX with long options or write call options for income. Of course, the third strategy can blow up if the volatility cluster continues. We'll discuss what that term means more below.

What do I mean by this? There has been a lot made about the best way for the masses to make the stock market benefit them on a wide scale. This is a very important and worthy goal. If you look at the difference between the top 10% of wealth in the United States population, who control two-thirds of the nation's wealth, it is quite easy to see the primary difference between them and the bottom 90%. They hold a much larger proportion of their wealth in equities, while the bottom 90% do not. This fact is also very crucially driving the unanticipated stickiness of inflation.

And if you look at a long-term stock market chart, you'll see that it always goes up, but there are difficult drawdowns. If you make mistakes and sell during these drawdowns, as so many people give in to the temptation, your portfolio can have difficulty recovering. This is why sometimes people like to use the 60/40 portfolio to control this risk; the purpose is that when the stocks go down, the inverse correlations cause the bonds to go up in value. Therefore, this enables a portfolio to weather drawdowns and continue achieving the compounding necessary to build long-term wealth.

This is the key, though, as you must be able to weather drawdowns through negative correlations. However, as so many of us witnessed and probably gnashed our teeth (I know I did!), stocks and bonds went down in unison in 2022. When this relatively rare occurrence happens, it is particularly hazardous to the wealth of hundreds of millions of people because the mechanism that is supposed to mitigate or avoid the drawdowns they must navigate successfully to build the wealth needed to achieve financial escape velocity breaks down. It is reminiscent of when the nuclear staff at Chernobyl pressed the emergency switch, and it only made the situation far worse. But if you thoughtfully use volatility, you can beat other solutions.

It is because the 60/40 has an antiquated design, but I believe the answer is actually in what we fear most; the volatility we are trying to avoid with the 60/40 allocation is the answer to improve it. Now that it has been isolated by financial engineering and a suite of new products that can enable investors to profit when volatility spikes rather than merely panic sell, this, if implemented by discerning professionals, can be the whole ballgame regarding wealth augmentation.

Volatility is Our Friend; Our Enemy is Us

Long run is a misleading guide to current affairs. In the long run we are all dead." -John Maynard Keynes

The very mention of volatility gets people all hot and bothered. Worked up into a tizzy? Volatility? Should I sell everything right now? Should I move to cash? A guy who's really high up at this one firm told me CRE is about to blow up! AH! What should I do? The fact is that the risks even the most erudite and lauded Wall Street masters of the universe are worried about are rarely the risks that will derail markets. Markets are always stalked by the Black Swans we cannot imagine or perceive.

Furthermore, human psychology has a predictable and seemingly perennial collection of shortcomings that even-minded market participants can use to their advantage. One of the main things investors are gripped by fear instead of reason about is selling low and buying high. As silly as it sounds, this is a common outcome because of our psychological limitations, particularly for investors trying to actively manage their assets daily, weekly, or monthly. An important fact I always like to remind my readers is that when Fidelity did a study to determine which accounts were the most successful over time, they found something quite illuminating.

The most successful accounts were comprised of those who had forgotten they even possessed them. In forgetting, they spared themselves the ill-advised decisions that most investors use to cheat themselves out of the prosperity that America's stock market can give anyone with time, patience, and discipline.

Volatility plays particular tricks with our perceptions of money. It can also help ensure that we hold onto it despite the vagaries of financial markets.

I have covered the $VIX more accurately and extensively than anyone on Seeking Alpha lately:

• On May 15th, I introduced a multi-faceted theory on why I believed the VIX was relatively subdued in the post-COVID cycle.

• One June 22nd, after my VIX call paid off quite handsomely, I did another piece on why I thought volatility would remain subdued.

• On October 10th, I wrote an article urging my readers to short the VIX despite the vicious Hamas attacks that drove levels of fear to a fever pitch.

• In that article I recommended the December 20 $17 put options which paid $4.69 (entry $1.42) per contract on the date of settlement, and the December 20 $16 put options paid $3.69 (entry $0.91). This means they experienced a respective price gain of 230% and 327% in less than three months.

• Next, I recommended that folks short the VIX despite some climbs associated with building geopolitical risk as Israel and Iran engaged in saber rattling. I recommended using the June 18th $14 put options to short volatility. I recommended them at $0.52, and it closed on Tuesday, May 29th at $1.12, which is a gain of 115%, after losing a significant amount today. Still not bad for a month and change.

• I am convinced had I recommended options to directly short the VIX the results would have been similarly fortuitous. My theory on VIX suppression paired with fundamental analysis taught by some of the best on Wall Street makes me believe I can replicate these returns on a somewhat consistent basis, although any strategy would involve losses as well. However, I'm convinced proper loss mitigation and risk management make a cohesive high-alpha VIX trading strategy possible.

Volatility has several key properties that can help us understand it. One of its properties built into most models is that volatility today is similar to volatility tomorrow. In other words, it clusters. So, when volatility is low, it tends to stay low despite the impulse of the laymen to buy "cheap" hedges against downside moves. When guarding our hard-earned coin, we often focus on what could go wrong, but as the opening quote suggests, what can go right is perhaps even more important.

5 Things That Could Go Right And Result In Subdued Summer Volatility And What You Should Do About It

1. Inflation Could Become Quickly Subdued: There are only a few key areas keeping inflation elevated, namely the OER Shelter component. If there is a collapse in this, like many had been anticipating, the inflation numbers will soon be very close to (or even below) the Fed's 2% target. The consumer has been strong, and the labor market has been, too. Still, the eventual reversal of momentum, if orderly, should result in inflation no longer being a major concern. A reversal in other areas like Motor Vehicle insurance or a collapse in Energy prices could accelerate a move and change the discussion quickly.

2. The Concentration of Wealth Can Actually Aid in an Ordered Economic Slowdown, or Soft Landing: The excessive concentration of wealth can get a lot of people upset, and there's of course legitimate reason for that. It's a free country here in America, and we encourage dissent and spirited disagreement with each other through our hallowed and unshakeable liberal institutions. But a lot of the strength in the economy is because there is a group of US consumers, tending to be older in age, who basically have unlimited spending power, a willingness to use it, and are completely insensitive to rates for a variety of reasons. This is one positive aspect of our how economy has changed strictly in the context of its seeming effect of making the all correlation go to one panic sell-offs associated with economic slowdowns less likely. There are no economic slowdowns for America's rich, at least with the added benefit of the stock market at all-time highs and the corollary wealth effect.

3. Geopolitical Conflagrations Could Simmer Down Unexpectedly: I have written several times about how geopolitical concerns regarding the market are often misplaced and almost histrionic rather than rational. The events in the Middle East, for instance, scared markets desperately, but a careful analysis would have suggested that a certain strategic parity created by geographic distance and a precarious domestic political situation in both Israel and Iran for their leadership would check this. Shorting the VIX on this understanding has proven very profitable very quickly for those seeking alpha. Recent events in Taiwan strike me as political kabuki. The CCP is not in a position of strength, and I also think that a cross-channel invasion of Taiwan could be made quite an ill-fated expedition by the much more capable US military. In Ukraine, renewed aid could also result in Russia finally reaching a critical mass of casualties that sharpens domestic opposition to the war at home. In other words, positive developments in the geopolitical spectrum could help out a lot of things that are keeping markets back. Overall, I operate on the assumption that our own fears make us more fearful of our adversaries than we should be. American military, economic, and political power are exponentially greater than the layman perceives. (and I consider many people on Wall Street laymen when it comes to matters of government).

4. Positive Earnings and Technology Momentum Should Increase Market Confidence and Bring Dry Powder Into the Market: It is becoming increasingly clear to many institutional investors that Nvidia is certainly not a bubble and not only that, but that for the sake of their careers they can no longer afford not to own it. The Magnificent Seven earnings (all of which I covered before or after earnings this cycle) were all positive and showed that Big Tech still has its swagger. But the rest of the economy remains strong if it slows healthily in some areas. As my wise former boss and market mentor, Tom Lee points out, there is about $6 trillion in cash still on the sidelines.

5. Seasonality of Volatility Suggests Next Few Months Should Be Subdued: Volatility is poorly understood because it can only be understood one moment at a time. While historical volatility is our best guide, it is always limited, and despite the famous John Templeton quote, this time is ALWAYS different. Nonetheless, historical volatility is as good a resource as we have without getting very into the mathematical weeds (which we'll discuss in a further version.) The point is, despite the fact that many people feel now is a great time to buy calls on the VIX, the seasonality of the VIX suggests that the opposite is true. Now would be a better time to sell calls on the VIX, and remember, one of the great things about selling calls on the VIX is that they are European expiration, which greatly benefits the sellers.

So, that leaves a trade on the VIX. However, instead of using the long side of the contract this time we will use the short side. And there is considerable risk here, but you can mitigate easily by using some of the premiums you collect to buy call options in case things go against you, depending on your risk aversion. You can also use them to buy put options when/if the VIX experiences a minor reversion spike if you want to press the trade extra aggressively. This is what I would recommend based on today's spike. You combine it based on your risk aversion and financial goals:

• Sell August 21 $17 or $16 VIX calls or lower dollar puts if bearish. If conservative, then purchase some higher dollar $VIX calls at August 21 $19 or $20 in a a larger quantity than what you sold, even if you need to inject more capital. If you are aggressive, you could use the premiums to purchase August 21 $13 or $12 put options, or at least subsidize it with the premiums in both cases.

• That is it, I think you can implement this trade to your customized needs, and I wouldn't recommend investing anything you can't lose in it as these are highly risky and finicky instruments. Shorting volatility always presents MAJOR risks and should not be done by novice investors.

Risks and Where I Could Be Wrong

Sometimes the early bird gets the worm, but sometimes the early bird gets frozen to death." -Myron Scholes

The old proverb is that this strategy is picking up pennies in front of a steamroller. This saying always makes me laugh because it seems like a pretty doable task if you're physically fit and present enough to keep ahead of a slow-moving and ponderous piece of equipment. Still, there is something to it. The hardest part about volatility strategies is that it is nearly impossible to detect when the change in what undergirds most volatility models on the street becomes moot. That rare time when volatility tomorrow will be very, very different from volatility today. Any of the things I mentioned that could go right could go wrong and cause such an event.

• A strengthening U.S. dollar is always a potential headwind for stock earnings and could result in elevated volatility.

• Commercial Real Estate blow-up causes a credit event.

• Inflation continues trending higher or staying put.

• Increased political risk during an election year.

• Fed policy error or banking crisis reignites.

The above risk could also cause any short volatility strategy to wildly fail and blow up in my and your face. I want to be clear. This is a risky strategy, but I do have similar ones that have recently paid off very well. If there is a spike in volatility between now and then, trust the seasonality and use it to lower cost basis unless I give an alert to do otherwise.

Conclusion: Making Volatility Your Friend Gets You More Alpha

Hedge funds have known for years that monetizing volatility is one of the surest ways to beat their competitors and the benchmark. Mastering volatility almost requires simultaneously mastering the mind. It requires us to be at our highest level of equanimity when it is most difficult to do so. Still, the math is clear and has been for a while. Succesful volatility strategies add a lot of potential for outperformance.

Luckily, financial markets have evolved at a rapid pace over even the past decade. Now average investors can use volatility trading strategies to achieve alpha that was once out of reach for them. My recent recommendations have proven that volatility trades that are relatively accessible can provide outsized gains. I suspect this opportunity will prove the same point again. Please feel free to reach out directly to me with any questions. Have a great week!

Analyst’s Disclosure: I/we have a beneficial short position in the shares of VIX either through stock ownership, options, or other derivatives.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.