By Lior Alkalay
Senior Analyst, eToro
As a die-hard bull in the investment community, I have been asked repeatedly if I still stand behind my bullish outlook for the Euro, indices and Gold. To the surprise of many, my view hasn’t changed much though I now employ a buy on the dips strategy. However, recent turbulence does call for some shift in strategy, but not direction. I’d like to share how professionals deal with market volatility and risk without having their portfolio take a whipping.
First, understand that there is a relationship between volatility and liquidity, and second, it’s important to identify the kind of asset that can benefit from that relationship. What many don’t realize is that volatility is actually a direct result of lack of liquidity; when liquidity is scarce markets tend to be volatile and when liquidity is abundant, then volatility is limited. Of course, there are exceptions; i.e., Wall Street’s major markets have been relatively stable, even as Europe’s markets are hectic.
This suggests that the “correction” in U.S. indices has been more cyclical than crisis related. As an investor, I feel no need to protect myself from cyclical corrections and rather use them to buy more and benefit from low-priced equities and inflation-linked assets like Gold. However, when the correction is related to a liquidity squeeze this could mean the risk of a real crisis is close to materializing, a scenario I would definitely like to protect myself from, but how?
One might consider an exposure to “safe haven” sovereign bonds from the U.S. or Germany. But what kind of a protection would that really provide if it is yielding almost zero? What the average investor can be certain of is an eventual loss, because once tensions ease, bonds will certainly yield more than zero. Even if I hold bonds in my portfolio they won’t make up for the potential lose in the risk trades I am also holding. Finally, bonds tend to move divergently to equities, which could create headwinds to future returns when markets stabilize.
So what then can be used to protect my investment? Very simply: the VIX or so-called “fear index,” which is an index which gains its value from implied volatility through options in the S&P500.
How does the VIX Protect your portfolio?
Before purchasing a VIX unit, one must understand something about the protection you are about to buy. The VIX represents implied volatility on the 500 largest stocks in the U.S. Unlike European volatility indices, the VIX has remained stable and continues to fall lower because the U.S. is deemed stable relative to Europe and somewhat insulated from their debt crisis. The only reason the VIX might rise sharply is if there is a perception that their debt crisis could spill over to the U.S.
As a bullish investor that would be the perfect scenario to hedge again. Bonds gain nearly every time stocks fall and do not necessarily suggest a changing trend. However, a jump in VIX to historical highs suggests that the debt crisis is drilling into the rest of the economy and a transition from a bullish to a bearish scenario. Considering the VIX is close to lows it hasn’t seen for years, it is pricing an extremely bullish scenario and is, therefore, a cheap hedge.
Crunching the Numbers; Why the VIX is Cheap
Currently, the VIX is trading around the 22 level, considered extremely low risk; comparatively, the record low was around 15 in 2007, back when the world was still “normal.” On the chart above we can see the VIX surged to around 40-43 with each escalation of the current debt crisis, and it had spiked above 70 during the peak of the U.S. credit crisis. If things continue to be normal and stable, with no crisis looming, then the VIX could slide to 15, around a 30% drop. But with a crisis, the VIX could jump to 40 or 70, a rise of 100% and 200%, respectively.
So what are the risks and the odds? Let’s say I have a portfolio heavily invested in stocks and allocate 10% of my holdings in VIX.
If things “normalize” I will lose around 3% of my 10% allocation in the VIX, while my 90% exposure to indices will gain significantly more. In the event of another credit crunch and subsequent collapse in stock prices, the VIX could jump to 40 and by that protect me from at least a 10% drop. So what about a Greek exit? Well, it could push the VIX towards 70, which could protect my portfolio with up to 20% drop.
Considering we are at the year’s low, there has to be an utter meltdown to fall more than 20%, although anything is possible. So for the investor that wants to continue to buy stocks, a VIX unit at this level could provide cheap protection for exposure to stocks. Of course, the VIX is not a “safe” asset like Treasuries; in fact it’s not a conventional asset at all and may carry more risk than regular assets, but my philosophy is to buy protections only when they are cheap, otherwise it’s more of a risk then protection.