- January 21, 2021
- Posted by: Stratford Team
- Category: Markets
Dave Jilek is the chief investment strategist of Gateway Investment Advisers.
Gateway Investment Advisers
- Dave Jilek is the chief investment strategist at $9.6 billion Gateway Investment Advisers.
- In an interview, Jilek lays out the lingering concerns that are keeping the VIX at above-average levels.
- He also shared a strategy for investors to take advantage of the widening volatility risk premium.
- Visit Business Insider’s homepage for more stories.
It has been a tale of two cities for the US stock market and the CBOE Volatility Index.
Despite the market’s continued rally towards record highs, the VIX, which is popularly referred to as Wall Street’s fear gauge, has remained steadily above its long-term average of 19.3 points. The VIX and S&P 500 tend to move in opposite directions because the demand to hedge future volatility falls as stocks rally and vice versa.
Meanwhile, it was hard not to notice that the VIX had plunged to a relatively low level of 21.89 as of midday Wednesday compared to its peak of 85 last March during the depths of the coronavirus-induced market crash.
“The VIX is a forward-looking pricing of volatility, so even though markets have been advancing, there are still multiple risk factors that are kind of weighing on the market’s mind,” said Dave Jilek, the chief investment strategist at the $9.4 billion volatility-focused money manager Gateway Investment Advisers.
None of the risk factors is new or unknown by any means, but they still signal uncertainty ahead. Specifically, top of mind for investors are concerns over the smooth and speedy roll-out of vaccines as well as their potential economic impact.
“The vaccine roll-out has been slower than expected,” Jilek said. “That contrasts with the significant market rally that occurred in mid-November when approval of the vaccines was announced.”
He continued: “I think that is a good illustration of how the market can continue to advance on positive developments, but there are clearly still risks and uncertainty that lie ahead.”
On top of that, the spread of the virus and its variants could continue until vaccine uptake reaches critical mass. That leaves the potential for new lockdown restrictions which could hamper the economic recovery.
What are VIX futures saying?
With a lot of the pandemic-related macro influences still in place, it is no wonder that VIX-futures pricing at the end of 2020 pointed to a continuation of the volatility environment that existed in the second half of last year.
“Anytime the VIX is above average, it can certainly continue to trend down especially if the news around the pandemic is generally positive and markets continue to advance,” Jilek said.
However, investors looking to wager on the low-vol trade should think twice given the wide variations of volatility in the past year.
“Three years ago, seeing the VIX in the mid-20s would be very attractive to an implied-volatility selling strategy,” he said. “Today, given the wide range that we’ve seen in the VIX recently, it’s a pretty dicey proposition to be straight selling volatility at these levels.”
Jilek is not the only one to have pointed out what the VIX futures have been trying to tell investors lately.
Nicholas Colas and Jessica Rabe, founders of DataTrek Research, wrote in a January 8 research report that the options market is pricing US stock market volatility out through August 2021.
They mapped the VIX term structure, which describes the relationship between VIX futures prices and maturity dates, in the chart below. The VIX’s close on January 7 is represented by the green dotted line at the bottom while the rest of the out-month observations are in blue.
“[The] options markets are not convinced that the strong start to 2021 is sustainable. Fair enough, we say,” Colas and Rabe said in the report. “But in that graph above you can actually see the “wall of worry” (January to March) that bull markets have to climb according to the old Wall Street adage.”
They continued: “This is not a complacent market, for all the easy returns that have been on offer of late. Not at least according to the VIX chart, anyway. That makes VIX futures as much of a contrarian bullish signal as warning sign of things to come.”
How to take advantage of elevated volatility
With elevated volatility in sight, the volatility risk premium, which measures the spread or differential in price between implied (forward-looking) and realized (historical) stock market volatility, has the potential to remain attractive in 2021, in Jilek’s view.
“That differential hit record positive spreads at various points in 2020, and that spread has sustained,” he said. “The standard deviation of the first 10 days of the year for the S&P 500’s realized volatility is just under 12%. Whereas the VIX has averaged almost 24 so far this year, so that’s almost a 12-point spread between the two.”
Jilek explains that the spread represents an attractive opportunity given it’s usually a little under four points.
He said investors can take advantage of that positive spread by selling volatility through various instruments, but that is also an extremely risky bet because volatility can spike at any moment. (Think last March when the VIX shot up to 85 and the “vol-mageddon” of February 2018 when the VIX doubled in two days.)
“The relationship between implied and realized volatility, though it is usually positive, can also flip negative,” he said. “Our approach is to avoid making a bet on a particular volatility level or making a bet that this implied versus realized relationship will remain positive.”
He continued: “We use the selling of S&P 500 options as a hedge to our market exposure rather than an outright bet on volatility…The higher implied volatility is and the more spread there is between implied and realized volatility, the more effective our hedge is going to be.”