Wednesday, August 24, 2016

It's Quiet...A Little Too Quiet

Embrace the volatility, VIX option

For the most part I've been on the investment sidelines for much of the past year.  Part of that was due to not seeing many investment opportunities, but mostly it was due to having other needs for our cash.  The past year has seen both of us without a full time job at the same time, the birth of our daughter, becoming a SAHD and so many other changes.  Unfortunately just about everything requires cash which means investing has been on the back burner.

One of the advantages of being on the sidelines is that I get to sit back and just observe.  Something that's surprised me a bit is the lack of volatility this year.  For the most part the major indices have taken after the tortoise rather than the hare this year.  Even more so since the "Brexit" vote.

The reason I'm surprised is that what's really going right with the economy right now?  For the most part companies are reporting earnings declines and are barely meeting the lowered analyst expectations.  The worst part is that companies are still showing earnings declines ex-currency and ex-anything bad, but the market continues higher.

Just some perspective on the earnings front for the S&P 500.  Q1 2016 earnings for the S&P 500 was $86.44 per share.  Q3 2012 earnings for the S&P 500 was $86.50.  The S&P 500 was trading around 2,060 at the end of March of this year compared to around 1,441 in late September 2012.  So the same earnings basis is somehow justifying over a 40% higher P/E multiple.

The U.S. dollar remains strong and is likely going to get stronger over the intermediate term which will be a further drag on multinational companies.  

The U.S. has been in a ZIRP since 2008 with many of the other developed economies in the same boat.  Even more surprising is that some central banks have even taken a NIRP approach with negative interest rates.  Although Chairperson Yellen might actually sneak in an interest rate increase this year.  

Here in the U.S. we're also in the midst of a pretty insane election year.  Personally I can't stand either one of the two major party candidates and the election year rhetoric is just about to start ramping up.

We're also coming off of the traditional summer lull and moving quickly towards the more exciting months, if you believe in any calendar cycles.  Traditionally we see lots of market action from September through the end of the year with October being especially bearish with many of the largest declines.

Between companies with weak fundamentals, low or no growth, stretched payout ratios, lofty valuations, a possible interest rate hike, and an election year with 2 candidates that I don't trust, I'm not exactly optimistic.  Also don't forget there's always the possibility of a black swan event coming along that no one is expecting.

Also just about every investor sentiment indicator is flashing in bright lights saying buy, buy, buy.  Unfortunately those sentiment indicators are usually a contrarian indicator as far as returns go.  If everyone's happy, get worried.

My general thesis on the markets can be summed up with this video.



Don't get me wrong I'm bullish on many companies over the long term and I have no intention to close my positions in hopes of timing the market.  I have a little bit of cash available, but not enough to make an actual purchase so I went looking elsewhere than an outright purchase.

**A quick note about the remainder of this article.  My long term plan is NOT changing, rather I just have some cash available and wanted to take advantage of an opportunity that I see.  Yes, there's market timing involved, but it's a risk that I'm willing to take.  Plus it juices up the excitement factor from the relatively boring slog that DGI is when you're only getting dividends and dividend growth.  This is a highly speculative, short term trade although I believe there's adequate risk/reward.

What do you do when you see trouble ahead?

Market timing is extremely difficult to get right and likely no one will do it consistently for any significant period of time.  However, my concerns for the current market levels and especially the market sentiment is very high.  

The Volatility Index, "VIX" is essentially at unheard of levels to the low side, especially when you factor in the all of the concerns mentioned above and many others.  Low VIX levels correspond to high complacency and the market loves to change when everyone is piling on in one direction.


Volatility VIX Historic Prices
Historic Price Levels of VIX
Over the past 10 years the VIX has only been at its current levels 2 other times, in late 2006 and briefly in 2014.  The average level over the last decade is 20.62 which is about 70% higher than the current level.

You'll also notice that the VIX ramps up extremely fast once fear takes over the market and sentiment changes.  50%+ gains in a week aren't unheard of.  

When you add in my concerns regarding the markets levels and the VIX at all-time lows I decided to make a concerted bet on the markets over the next 3 months.

Buying to Open

On August 22nd I bought to open the $14 strike call option on the VIX that expires November 16.  Being on the buying side of the call option means that I had to fork over the premium as opposed to receiving it.  For this specific call option I had to pay $4.40 x 100 + commission/fees = $445.64.

In a nutshell I'm going long volatility over the next 3 months, but can sell to close the position at any time between now and the expiration date in November. 

The following chart shows the approximate P/L scenarios at different closing prices of the VIX Index on the expiration date.   


Profit/Loss Graph of Long VIX Call Option

My breakeven price is a VIX Index level of 18.46, anything less than that and I'm losing money.  The downside on this trade is capped at my cost of $445.64, but the upside is theoretically infinite.    

To me the risk/reward ratio is pretty attractive.  Considering the average VIX level is 20.6 since August 2006 I like my odds.  If the VIX closes at 20.6 my return would be approximately $214 or 48% in less than 3 months.  Although given the VIX's habit of shooting higher really quick I think there's a good chance of a double or more of the investment if volatility does indeed spike.


Volatility VIX Historic Prices with breakeven

The red line on the graph represents the breakeven level on my call option of 18.46.  Approximately 46% of the time since August 2006 the VIX index has been at a price higher than my breakeven price.  Granted a good portion of that time was during the financial crisis.  Even if we only look from January 1, 2012 until now the VIX has been higher than my breakeven price 19% of the time.

If volatility spikes I will likely close out this trade prior to the expiration date in November in hopes of locking in a solid gain.  And who knows maybe a double of my money!

I have another chunk of cash coming in the next few days and if I can find another attractive trade like this I might double down on the VIX and embrace the volatility.

Do you expect an increase in volatility over the next few months?  Are you positioning your portfolio to embrace the volatility or just marching forward with your plan as is?  What do you think about the risk/reward scenario with this call option?

Please share your thoughts in the comments below.

6 comments:

  1. JC,

    I like your bet and wouldn't be surprised if you doubled your money, or more over the next few months... This amount of non-volatility is surprising, even for the summer months which are traditionally slow and boring... I also expect a ton more volatility in the fall season.

    Right now, investors are getting complacent and lazy... The writing is on the wall here... The major indices are all making new record highs while earnings are uninspiring, to say the least... This is what a market top looks like and it will not end will for the retail investor.

    Market timing is tricky, but we all know to "buy low and sell high"... I think anyone can figure out if the markets are currently low or high... It's blindingly obvious... And with regards to market timing, it gets such a bad rap but if you are successful in playing 1-2 cycles, that's early FI gifted wrapped and handed to you on a silver platter... It's not like you have to keep on market timing for the entirety of an investing career... Buy and Hold Forever is all the rage these days, but it doesn't have to be the only option for investors. Sitting on the sidelines is a perfectly reasonable (prudent) strategy that can really "pay dividends" if it sets you up for a deep value play down the line to really make some phenomenal gains.

    Best wishes!

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    1. FI,

      I think a double or triple isn't out of the question, although a triple+ would likely need the VIX and volatility to spike right near the expiration date.

      Unfortunately this trade if it works out wonderfully isn't about to generate life changing kind of returns, but I'm definitely not going to complain about any kind of return. I hope that the first part of next week is calm and the VIX drops because I'd love to add on another call with a December expiration date. The biggest problem with the call option is that if my timing is off then it doesn't matter how right the idea was.

      Market timing does get a bad rap but I think there's some much deserved criticism against it. For starters I don't think many people are as fluid in their investment approach as you are. You have no issues going to real estate, single stocks, the gold miners...whereas I think many people try and stick with one thing. Plus the market timing label gets thrown around a lot. I personally don't think what you've been doing is market timing rather just a more aggressive form of value investing where you're not afraid to "take your ball and go home" after you're done having fun.

      Deep value investing isn't market timing. It's not easy and you need patience, but it's not market timing. The key difference, for me at least, is that deep value investing is based on fundamentals. You know the value range of the assets you've invested in and if they get way too low you buy, way too high you sell. Whereas market timing is more akin to the late 90's tech bubble where there was no fundamental basis behind many of those companies and your returns were only going to come from another sucker coming along to pay an even more unjustifiable price for a sh!t company. In many cases they didn't even have actual profits or positive cash flow.

      Thanks for stopping by!

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  2. I've never bought an option. Very exciting ;-) I like this position.

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    1. IH,

      I much prefer to be on the selling side of options rather than the buying side because time works in your favor that way. I think the thought process behind the option is solid but the biggest concern I have is that I can be 100% right that an increase in volatility is headed our way, but if the timing is wrong I can lose out. That's why I've got just a small bit of capital tied up in this although if we do see more complacency and lower VIX levels I'm looking at adding one more option with the Dec expiration and likely a lower strike.

      All the best.

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  3. Now that's a great way to fight off the boredom! All the best with this trade -- hope it goes well for you!

    (Also because I'd like to see a little more volatility for options trading!)

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    Replies
    1. Ferdi,

      This move definitely strays from my normal method of investing but I think the risk/reward is pretty good. We've had some of the least volatile period of investing ever over the last few weeks and I think it's bound to rise from here.

      Thanks for stopping by!

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