Volatility Expansion: Short Term Pain, Long-Term Gain

With the S&P 500 back to within 1% of its all-time high, it may seem like a distant afterthought that investors were dosed with a wave of unexpected volatility on Monday August 5th.

In the days prior, the S&P 500 fell a combined 3.2% on Thursday and Friday, with a disappointing jobs report masquerading as the main catalyst behind the pullback. However, something much larger was lurking beneath the surface: The carry trade.

As the carry trade in the Japanese yen unwound, volatility began to creep higher until we got to Monday’s session. That’s when volatility exploded and the S&P 500 opened the session lower by 3.65% and fell as much as 4.25% at its intraday low.

While buyers quickly materialized and volatility ultimately compressed, it was a bumpy couple of days before bulls eventually emerged as the victor. Naturally though, it got us wondering about what large moves in volatility — both volatility expansions and contractions — mean for investors.

Measuring Volatility

For many investors, the most popular way to observe volatility is through the CBOE Volatility Index — also known as the “VIX.”

The VIX is often referred to as Wall Street’s “fear gauge,” as it generally moves lower when stocks are calm and rallying, and spikes higher when markets are volatile and under pressure.

However, it’s not quite that straightforward.

The VIX is calculated by a combination of SPX put and call prices over the next 30 days. So when the VIX was trading near a high of 65 on August 5th — its highest level since the Covid-19 selloff in 2020 — it was a bit misleading as low liquidity made it look like the VIX was soaring.

That’s not to say that volatility wasn’t rising — it certainly was — but not to the degree we seemingly saw on Monday morning. For instance, the VIX futures only climbed as high at $37.10.

That all said, the VIX still rallied significantly on August 5th, evidenced by its ~65% gain on the day. That was its second-largest one-day gain ever recorded going back to 1990.

Volatility Expansion

When volatility expands, it tends to come at a time when uncertainty is on the rise. That was the case in the most recent instance, too. That’s with geopolitical turmoil persisting in the Middle East, political uncertainty surrounding the next US president, and perhaps most notably, worries over the US economy increasing over the past few months.

Throw in a forced unwind of a leveraged currency trade most investors are unfamiliar with, and it’s no surprise that the VIX jumped significantly.

But there’s good news when it comes to these scary stretches of time. When looking back at previous instances, jumps in volatility have actually been opportunities for long-term investors to buy — not to sell into the panic.

Excluding August 5th, there have been 21 other instances where the VIX climbed more than 40% in a single session. One year later, the S&P 500 was higher 90.5% of the time with an average return of 18%. Otherwise, it's higher about 70% to 75% of the time one, three, and six months later (as noted in the table above).

In other words, it can be a painful ride in the short term, but often creates opportunity over the long term.

Volatility Contraction Can Be Good Too

Interestingly, volatility contractions can also be a positive for long-term investors.

On Tuesday August 6th, the VIX fell 28.2%, the second-largest one-day decline it's ever experienced.

There's been 18 prior instances when the VIX fell by 20% or more in a single day. One year later the S&P 500 was higher 83% of the time, with an average return of 7.5% and an average gain of 16.1%.

Options Are a Double-Edged Sword With Volatility

When it comes to options, volatility can be your best friend or worst enemy.

Owning puts — either on individual securities or a broad-based index — can pay off when volatility skyrockets and asset prices plunge. These puts benefit from a double-whammy effect, where the spike in volatility increases the option price, while the drop in the asset price increases the value of the put.

Remember, volatility is one component to options pricing.

On the other hand, investors who are long call options really feel the pain when markets experience these quick and deep declines. While call options can benefit from increased volatility too — and thus increasing the value of the call option — this benefit is outweighed by the swift decline in the underlying asset.

For investors who were overallocated in call options — particularly for those who were overallocated in short-dated call options — these swift declines can leave a painful impact on one’s portfolio.

Even when the market recovers — like it has in August 2024 — owning calls with too little time to benefit from the rebound risks losing most or all of their value. Buying call options allows investors to know their total risk going into the trade, which is great! But knowingly taking too much risk can leave investors cursing volatility, when position sizing could have kept them out of trouble.