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The VIX index reflects the implied volatility of put and call options on the stocks in the S&P 500 index. Implied volatility is the consensus expectation of future price variance. Since options are price insurance, market participants purchase puts and calls during bearish periods and sell the options when prices head higher. The price action in the VIX signals that the stock market bull will continue to charge higher.
In an August 29 Barchart article, I asked if the VIX was too low or too high. In that piece, I wrote, “The economic and political factors facing markets remain why the VIX will stay elevated, and the odds favor higher instead of lower levels for the volatility index for as far as the eye can see.”
The VIX was at the 14.56 level on August 29, sitting between 14 and 16. Since then, the volatility index has made lower lows as the decline continues, with the S&P 500 sitting near the 2023 high and threatening to move above the record 2022 peak. I have been wrong so far, but at 13, there may be little downside risk in the volatility index.
The VIX continues to slip
The VIX moved steadily lower since reaching an 18.88 high on August 18
. The chart shows the decline to 13.02 on September 1. On September 7, the VIX was above the 15.50 level.
Stocks are fighting the Fed- Stocks have been winning
The S&P 500 index has been in a bullish trend throughout 2023.
The S&P 500 chart highlights the bullish pattern of higher lows and higher highs throughout 2023. The stock market rallied despite the Fed pushing interest rates steadily higher. A rising S&P 500 pushed the VIX lower as the demand for price insurance declined.
Inflation has been falling- Is the 2% target unrealistic?
The U.S. central bank has been vigilant in its monetary policy approach as inflation remains at the highest level in decades. While consumer and producer prices decreased, the core CPI and PPI data show more than double the 2% target inflation rate.
The annual Jackson Hole, Wyoming, Fed gathering statements continued the commitment to maintain restrictive monetary policy. While monetary policy can impact the economy’s demand side, which plays a role in reducing prices, supply-side factors can be another story. Over the past weeks, energy prices have been moving higher. Core CPI and PPI exclude volatile food and energy prices but can impact other costs as energy is a critical input in all goods and services. Therefore, the rise in crude oil and oil product prices since the early May lows will likely filter through the economy, stabilizing inflationary pressures at an elevated level. Similarly, rate hikes since March 2022 have a lagged economic impact, which could keep inflation under control.
The bottom line is the hawkish monetary policy may not be enough to reduce inflation as geopolitical factors are above the Fed’s pay grade. The 2% target is arbitrary, but the U.S. and other central banks agree it is the optimal inflation level. However, the ongoing war in Ukraine and the deterioration of relations between the U.S. and China/Russia have supply-side ramifications that could make the target unrealistic in the current environment.
The most volatility comes from the least expected events
Historically, spikes in the VIX occur when surprises shock the financial system.
The VIX chart dating back to 2004 shows the 2008 and 2020 spikes to over the 80-level during the 2008 global financial crisis and the 2020 worldwide pandemic. The two events surprised and shocked markets. While the war in Ukraine caused the VIX to move above the 38 level, it was not an event that came from out of the blue, like in 2008 and 2020.
Therefore, unexpected events are the most significant upside risks for the coming months and years. The bifurcation of the world’s nuclear powers, the war in Ukraine, Chinese reunification plans for Taiwan, and natural and other disasters increase the potential for sudden surprises that can cause the volatility index to soar.
The strategy for trading the VIX from the long side involves taking small losses in the quest for oversized profits
I believe the VIX is far too low at under the 16 level in early September 2023. I approach the VIX by purchasing the futures or VIX-related products like VIXY with very tight stops. When the volatility index declines, triggering stops, I attempt to reenter risk positions at lower levels with the same tight stops. The strategy allows for small and limited losses in the quest for much larger significant gains.
When the VIX rallies, I adjust the stops to reflect the current, not the execution price level. Therefore, I can ride the rising levels when spikes occur to optimize the long positions. There are no guarantees in any markets, but the VIX’s risk-reward at below 14 favors the upside as the range from 1990 through 2023 has been from 8.56 to 89.53. I am willing to trade small and consistent losses for a spike that more than covers the cost and provides a generous return.
The current VIX level tells us that stock market sentiment remains bullish. However, stocks are in an epic battle against a hawkish Fed, and the geopolitical landscape increases the odds of bearish surprises. Risk-reward dynamics support a higher VIX, but a strategy and the discipline to stick to the program are critical for potential success.
On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
