The nice attribute of volatility is that it is mean reverting. As I have stated many times, volatility is unlike other asset classes because it does have a predictable nature to it. We have a general feeling of what “feels” right as far as average daily moves in equity indices, and we can confidently say that in “normal” times that should be a standard deviation in the neighborhood of 8-15% per year. That normal annual standard deviation equates to about .5%-1% per day. Today, due to a risk flare in Greece and the grilling of Goldman Sachs with looming financial reforms we achieved a daily move of -2.34% in the S&P 500. Due to the decline in equities, implied volatility as measured by the VIX spiked 30% or 5.34 vol points from the previous close to 22.81%.
If you have read previous posts, I do believe that sovereign risk will continue to be an issue in the coming years, but I do not believe that Greece and Portugal will cause a global crisis moment. Profits at large US corporations are strong and I believe that there will be a rebound in US employment in the coming months. I am not optimistic about the future, but I do not believe we are at the precipice of the next crash. With that as a backdrop, I think this risk flare provides an opportunity to establish a short position in volatility, specifically VXX, over the next few days. Once VXX has a pullback as fear subsides, then you can place a hedge against your short position using the longer dated VXZ as I described in the VXX/VXZ pairs trade.