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Reverting to the Mean

Reverting to the Mean 

BY: HANS ALBRECHT, CIM®, FCSI, VICE-PRESIDENT, PORTFOLIO MANAGER AND OPTIONS STRATEGIST, HORIZONS ETFS

March 21, 2017

A crucial foundation for understanding how option volatility works is the concept of ‘mean reversion’. For a period, stocks can go up and stay up, and they can conversely go down and stay down. But option pricing will generally have trouble staying high or low for an extended length of time.

So why do prices eventually move back toward the mean or average? Shocks to equity markets happen, but over time markets usually find a way to digest those events. From ‘fiscal cliffs’ to Brexit to reality-star presidents – they’ve digested them all. Similarly, periods of low volatility usually come to an end as uncertainty invariably creeps back into markets at some point. So volatility reverts back to a more ‘normal’ level – a mean of sorts, hence the term ‘mean reverting’.

The weekly VIX chart below illustrates that we’ve been in a low volatility environment from quite some time, but that we tend to see a spike in volatility every four to five months. Dropping equity and sector correlation have certainly contributed to a low and coiling VIX. Ironically, stocks moving in separate directions have caused a kind of net effect of zero volatility from an index standpoint. But correlation is starting to rise again, which could put upward pressure on option pricing. In addition, with a potentially more aggressive Fed rate hike schedule, rising tensions in North Korea and a looming first round of French elections, we certainly have a few potential upcoming worries to choose from. We can only coil for so long.

vol1.png

Source: Thomson One, as at March 13, 2017.

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. and 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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