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Searching for Signs of Stress



October 2, 2017

Yet again, equity markets have very quickly digested the prevailing worry. Like Pavlovian dogs, most investors have been trained to buy the “equity dip”.

It is behavior that can feed upon itself and can create a self-fulfilling loop. For instance, a month ago, people didn’t seem worried for very long about President Trump’s provocative tweets towards North Korea. In fact, markets quickly rallied thereafter. A couple of weeks later, investors remembered the previous event’s behavior and bought equities even more quickly. Then last week, the market barely down-ticked on North Korea’s promise of an atomic bomb detonation.

And so it goes, strength begets more buying and low volatility begets lower volatility. In times of extreme market stress the opposite becomes true – investors react more nervously to each subsequent headline and option pricing can spiral upwards. That is certainly not the case these days, as records for day-to-day market movement fall on a regular basis. But what hasn’t followed through is what we call “volatility-of-volatility” (or “vol-of-vol”), namely the implied volatility for options on the VIX and similar volatility-related instruments.

Investors have been aggressively pushing up the price of out-of-the-money puts in equity index options. As a result, vol-of-vol hasn’t come down to levels we would normally associate in a 10-point VIX environment. Could this be a sign of worry? Actually, it’s more than likely a sign that investors are happy to stay long, but with protection. That’s not a bad way to go with U.S. markets making new highs almost on a daily basis. But I do like to keep an eye on vol-of-vol – it can sometimes reveal signs of concerns below the surface.


The VIX at near-lows for the year. Source: Thomson One, as at September 25, 2017.


VVIX – Volatility-of-volatility has been more resilient. Source: Thomson One, as at September 25, 2017.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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