As you all know by now, I’m not an investor that puts too much stock in my own market predictions or gut instincts. I rely 100% of quantifiable signals and probability theory. So for me (and by proxy anybody who follows my work) we navigate the day to day noise by remembering:
Everything in the market can be reduced to risk vs reward
If you want to know why a volatility product like the XIV for example can increase in value so quickly, we could talk at length about all the reasons because there are many, but at the end of the day it can essentially be dumbed down to the simple fact that it can also do the opposite. It can and does also crash just as spectacularly. It’s risk premium.
My last couple of daily blogs discussing the extremely high Beta values that XIV and ZIV have been showing in the last year have sparked a ton of great follow up questions.
My purpose is never to scare anyone, but we can only make sound investing decisions if we know all the risks which is why I talk about these subjects openly and honestly. Of course everybody wants to find that holy grail investment that will multiply our money in short order with very little risk, but that’s just not how the world works. There is no such thing as free money. The only products that can multiply money quickly are the ones that can also vaporize it just as fast.
It’s worth remembering: What we’re essentially trying to do here is turn some of the most dangerous products on the market into safer long term investments.
So of course we have to be mindful of things like rising Beta:
Another indicator I’d like to introduce today is SKEW
The SKEW Index is a measure of potential tail risk in the markets. It’s calculated from the prices of S&P 500 out of the money options.
A SKEW value of 100 would imply that the expected distribution of S&P 500 prices is normal. But because risk is always asymmetric to the downside (meaning markets can drop faster than they can rise) SKEW will always be above 100. How far above 100 is a matter of how much perceived risk there is in the markets.
Here is a 1 year chart of the SKEW Index:
So current SKEW is clearly on the high end compared to values in the last 1 year, but it’s hard to tell what this number means on a short time horizon.
Let’s stretch it out to 20 years:
Now we can see something quite interesting. Actually the “perceived” tail risk in the markets is at an all time high. Higher than before both the dot.com bust and the financial crisis.
Now of course perception, which is derived from options activity on the S&P 500 doesn’t actually mean it’s predictive. By very definition black swans are unpredictable, that’s why they are called black swans.
So SKEW on it’s own is as meaningless as the VIX Index on it’s own or any other indicator on it’s own. But taken as one piece of the bigger picture, it can be quite useful.
But getting back to the original statement, everything in the market can be reduced to risk vs reward.
Why is the XIV rising so much faster than the broad market?
– The XIV Beta has never been higher
– The SKEW Index has never been higher
– Volatility has never been this low for this long
– Only 1 bull market in history has lasted longer
– Political uncertainty is high
– Fed monetary policy is at a crossroads
– Valuation metrics are at extreme levels
– Debt is rising all over the world
– Interest rates are still near all time lows
Traders need to be compensated for taking on such high risk, and that compensation sometimes manifests in some outsized returns for the risk takers.
I’m not making any predictions here and I’m not a doom and gloom guy. Having said that, I’m sure as heck not going to ignore my set of indicators that have served me so well in the last 5 years. Head down, stay the course 🙂
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