Tuesday, March 29, 2016

Thoughts on Two Volatility Indicators

When the usual monthly results were posted ten days ago for the Mar2016 options expiration, it was noted that the Covered Calls Advisor was only 10% invested in next-month (Apr2016) positions and was 90% in cash.  Usually by this time each month (i.e. 10 days after options expiration), the opposite is true and new positions for the following expiration month have been established so that about 90% is invested and only about 10% is in cash.

Some readers have asked: Why haven't new positions been established yet for the Apr2016 option expiration?

First, the Covered Calls Advisor's 'Overall Market Meter' is Slightly Bearish.  But that indicator has been 'Slightly Bearish' since last November and I have continued to establish conservative in-the-money covered calls each month since then.  So being Slightly Bearish by itself is not a sufficient reason to delay establishing new positions with the available cash.  But the two charts below provide the additional rationale for being extra cautious now.

The first chart shows the S&P 500 Volatility Index (known as VIX) for the past 6 months.  VIX is sometimes termed the 'fear index' because it normally increases coincident with stock market declines.  Conversely, when investors are confident (perhaps complacent is a more appropriate term), VIX normally declines to around the 15 neighborhood, which is about where it is now.

As Covered Calls investors, we are options sellers, not buyers.  We sell Call options when we establish Covered Calls positions (as well as for their synthetically equivalent positions of selling 100% Cash-Secured Puts).  When VIX is low, options prices (premiums) are also low and thus provide a lower potential annualized return-on-investment.  But, this is true not only for the S&P 500; it is also true for most of the 500 individual companies that comprise it.  Just as VIX measures volatility for the S&P 500, 'implied volatility' (IV) measures volatility for an individual stock (at any specific time, expiration date, and strike price).

At the current level of 15, VIX is near the low end of its recent normal range of 15 to 25.  The second chart below shows the ratio of VIX to VXV.  Think of VXV as the markets' expected future value of VIX 3 months in the future.  As shown on the chart, VIX:VXV is also near its low for the past 6 months, so there is an expectation that VIX will be significantly higher 3 months from now (which implies a corresponding stock market decline from current levels during that time period).

In short, both VIX and VIX:VXV tend to fluctuate up and down between their high and low levels (i.e. they revert-to-the-mean).  With both charts currently near their lows, a stock market correction in the near-term future seems likely.

As you know, the Covered Calls Advisor is primarily a fundamental, value-oriented investor, so technical analysis like what is described in this article is not the norm.  When a market correction occurs (coincident with increasing implied volatility), you can expect that several new positions will be established and the Covered Calls Advisor will then return to the more normal fully-invested portfolio.  As a starting point for future reference, SPY opened at $206.30 today. As always, I will post the transactions for all new positions on this blog site on the same day they occur.

Best Wishes and Godspeed,
Jeff (the Covered Calls Advisor)