Even a lot of people who care nothing about art would
recognize “The Persistence of Memory” by Salvador Dali. It is the tiny
surrealist gem with the melting watches. It is an undoubted masterpiece and
shows how great Dali was before he decided being a celebrity was easier, but
that isn’t directly relevant here.
Volatility also shows persistence of memory. That is the
basis of the GARCH family of models. In the short term volatility persists. And
right now volatility is low. On March 30th, 2017 the VIX closed at 11.54. To
put that in context, this is in the lowest 6th percentile since the VIX was
first calculated at the start of 1990.
Based on this number it might seem like a good time to buy
volatility, either through options or VIX futures. There are two problems with
this idea.
The first is carry. If you buy VIX futures you pay the
basis. As of the 30th of March, the April futures are 1.26 points
above the cash index. This means that if the VIX stays where it is and you are
long the April futures, you will lose 10.9% in the next 20 days, or a startling
200% per year.
And options don’t help. If you buy options you will pay
implied volatility, but get paid out on the basis of realized volatility. And
when implied volatility is low, the realized volatility tends to be even lower.
The second problem is persistence. Just because volatility
is low doesn’t mean it won’t stay low. In fact the evidence suggests it will.
Here are the implied and realized volatilities of the
S&P 500 for each year since 1990.
Year
|
Implied Volatility (VIX)
|
Realized Volatility
|
Volatility Premium (Points)
|
Volatility Premium (% of VIX)
|
1990
|
23.0
|
15.9
|
7.1
|
31%
|
1991
|
18.4
|
14.3
|
4.1
|
23%
|
1992
|
15.4
|
9.7
|
5.7
|
37%
|
1993
|
12.8
|
8.7
|
4.1
|
32%
|
1994
|
13.9
|
9.9
|
4.0
|
29%
|
1995
|
12.4
|
7.8
|
4.6
|
37%
|
1996
|
16.5
|
11.8
|
4.7
|
28%
|
1997
|
22.4
|
18.1
|
4.3
|
19%
|
1998
|
25.7
|
20.2
|
5.5
|
21%
|
1999
|
24.4
|
18.5
|
5.9
|
24%
|
2000
|
23.4
|
22.6
|
0.8
|
3%
|
2001
|
25.6
|
20.5
|
5.1
|
20%
|
2002
|
27.4
|
26.3
|
1.1
|
4%
|
2003
|
22.2
|
17.1
|
5.1
|
23%
|
2004
|
15.5
|
11.0
|
4.5
|
28%
|
2005
|
12.8
|
10.2
|
2.6
|
20%
|
2006
|
12.8
|
9.5
|
3.3
|
26%
|
2007
|
17.5
|
15.8
|
1.7
|
8%
|
2008
|
32.7
|
35.6
|
-2.9
|
-10%
|
2009
|
31.5
|
24.2
|
7.3
|
26%
|
2010
|
22.5
|
16.5
|
6.0
|
26%
|
2011
|
24.2
|
21.1
|
3.1
|
12%
|
2012
|
17.8
|
12.6
|
5.2
|
29%
|
2013
|
14.2
|
10.8
|
3.4
|
24%
|
2014
|
14.2
|
11.1
|
3.1
|
21%
|
2015
|
16.7
|
14.9
|
1.8
|
8%
|
2016
|
15.9
|
11.6
|
4.3
|
28%
|
Obviously what follows isn’t a rigorous statistical argument,
but if we look at the 5 years with lowest average VIX, we also see an average
volatility premium of 30%. This compares to an overall average of 21%. Based on
this, low volatility is a sale. When
implied volatility is low the subsequent realized volatility is even lower.
Also, look at the period 1993 to 1995. The VIX averaged 13
for 3 years. Then between 2004 and 2006 the VIX averaged 13.7. While volatility
was low, it stayed low for a long time. The converse is also true. High
volatility also tends to stay high.
Volatility reverts to its long-term mean. This has been well
accepted and internalized by most traders. But volatility also persists, and
the persistence can dominate for years. I used to sign my books, “buy low, sell
high”. I was wrong. When it comes to volatility; sell low, buy high.
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