Low volatility offers opportunities to buy

LOOKING at the headlines, you probably wouldn’t draw the conclusion that the financial markets are currently a sea of calm. There’s political uncertainty in both the UK and, to a lesser extent, the US. Sovereign debt risks are mounting in the developed world with the Eurozone still in focus and the UK a concern if it can’t get its fiscal troubles in order following the general election.

It may therefore come as a shock that last week, the Chicago Volatility Index (Vix) hit its lowest level since May 2008 touching 16.5 on Thursday. Compare this to the record high of 89 that it reached in October 2008. The Vix is constructed using the implied volatilities of a wide range of S&P 500 index options, and the steady rise that we have seen in equity markets over the past year has reduced traders’ uncertainty and need for buying insurance against market turmoil in the form of put options.

So it is not entirely surprising that the Vix has managed to head lower since early 2009, given that the more trend-based the indices are, the lower the volatility, says WorldSpreads’ senior derivatives trader Alastair McCaig.

But surely with the economic recovery still unconfirmed and the markets still prone to wobbling on sovereign debt concerns and rumours of bubbles in China, should the so-called fear gauge be back to its pre-crisis levels already?

Contracts for difference (CFDs) traders looking at the Vix should be aware that volatility is not the same as a downturn in the market. It is perfectly possible to imagine a scenario where the market falls yet volatility manages to remain low. This would occur if the markets are all moving in one direction and, as such, nobody is uncertain about what’s going to happen.

But the current level of the Vix certainly prompts a buying opportunity for traders who think that we may see plenty of volatility in global stock indices over the coming months. Indeed, Saxo Bank’s Ole Hansen says that looking at history, we have often seen that a Vix reading below 20 has been followed by a major sell-off shortly after.

Tim Hughes, head of sales trading at CFD-provider IG Markets, says that we could very easily see it going from the current level to the 30 mark that we were at back in January, and if there is a proper double-dip recession then the Vix could quite feasibly go back towards 70.

The majority of the major CFD providers offer futures contracts on the Volatility Index, including IG, GFT and CMC Markets, with fairly competitive spreads – GFT offers a spread of 0.10 basis points plus the underlying market spread with a margin requirement of just 1 per cent.

However, there are other ways to take a punt on market volatility, says IG Markets’ Hughes. Since options are priced in part using implied volatility, you could trade these using CFDs. In order to buy an option CFD you have to pay a premium, just as you would if you bought an actual option, and this premium is the most that you would lose if the trade went against you.

The cost of buying this premium falls when volatility is low so you can pick up a CFD on a put option, which bets that the FTSE will be at 5,300 by June for just 100 points. You would therefore only need the index to hit 5,200 – hardly inconceivable – in order to make this trade a profitable one. And if the index ends up being volatile but in the wrong direction, then you only lose your premium rather than the unlimited losses that a traditional CFD or spread bet would expose you to.

If you are sceptical that the markets have returned to pre-crisis peace and calm, then taking a bet on the volatility index directly or on assets such as options, which are priced using volatility, can be an alternative way for bears to take a view on potential market turmoil in the months ahead.