Stock Talk School: Volatility for Traders = Opportunity for Investors

Chief Investment Officer Chris Perras for Oak Harvest Financial Group, a wealth management and financial advisor in Houston, Texas, discusses volatility and a potential upcoming early-summer pullback in the markets…

Speaker 1: Hey there. I’m Chris Paris, Chief Investment Officer at Oak Harvest Financial Group. We are a wealth management and financial advisor in Houston, Texas. Welcome to our April 9th weekly Stock Talk Podcast: Keeping You Connected With Your Money. Well, the S&P 500 continues to reaccelerate to make new all-time highs, hitting almost 4100 yesterday. We previewed this likely reacceleration in the markets being led by technology. Well back in January. This week’s podcast is going to address, in more detail, the topic of our fifth myth of last week’s podcast. That topic is one of volatility.

At the end of this podcast, we’ll once again preview the timing window for the coming summer pullback in the markets. The topic of stock market volatility is one of my favorite topics to discuss because so many people on TV talk about it but so few people understand it. It’s like in the movie The Princess Bride which I’ve talked about in the past when actor Mandy Potemkin’s character, Inigo Montoya, responds to Vizzini’s inconceivable line. He responds to this line with his own quote, “You keep using that word. I do not think it means what you think it does.”

When most strategists and advisors I hear on TV discuss volatility as high and even extreme, they say they expect it to stay that way. Well, the first two parts of that statement are categorically false and the third, we believe, will continue to be incorrect through the first quarter of next year excluding one brief bout of increased volatility early this summer.

You may have a negative connotation of the word volatility, and it might be for a good reason, but what is volatility really? It is most often used when things are bad or expected to be more turbulent sooner rather than later. It is an emotional word when used in financial context, but its use and connotation shouldn’t be negative all the time. Listeners, the word volatility if you look it up in Webster’s dictionary, its definition does not mean bad or good or emotional. In finance, volatility simply means the change in price over a given amount of time. That’s it, price changes up or down over a given time period.

It is just the actual price movement of an asset. That being said, I know probably 99% of my listeners do not think of rising stock prices from say 1% up to 3% up to 5% up s a bad thing in their portfolios, even though this is by definition volatility. They love that positive trending volatility much as they like positive surprises and they dislike negative surprises. They like the ones, “Well, you won the lottery,” that sure beats, “A tornado has just destroyed your ranch.” Both are surprises but they have opposite emotional responses.

Most people on TV quote the VIX spot index as their measure of stock market volatility or uncertainty. Some go so far to call it the fear index. Listeners, that is a misnomer. Most of the constant flow of information on TV, the Internet, and your news feed is nothing but noise. However, buried deep within those data points. CBC stories and breaking news headlines are hints to what will happen in the future.

We have to determine what is a true signal and what information is just noise and that is what makes the difference between those people who make money and those who lose money based on unpredictable noisy movements. Listeners, you cannot buy the VIX index that everyone on TV speaks of when they talk about volatility because the spot VIX index is purely a math calculation built by the Chicago Board Options Exchange based on a basket of options that expire over the next 30 calendar days. It is interpolated from a wide range of strike prices in the stock market.

The number quoted so often on TV is a math equation. That is it. It’s literally the market’s expectation of 30-day volatility for the broad index based on the difference between some options that are calls and some options that are puts of the S&P 500 the main VIX index calculates 30 calendar days of implied volatility in real-time. Remember that word, implied volatility. Listeners, the VIX is not an ETF. The spot VIX index does not trade and cannot be bought or sold. It is just a math calculation based on implied volatility somewhere out in the future. Once again that word showed up, implied volatility out in the future, not the actual or realized volatility that you see crossing your ticker every day, every hour every minute of the lower level of the TV that scrolls by in the financial news networks.

Over time, there’s a natural tendency of implied volatility to go up, just as interest rates would normally tend to be higher for longer time periods in the future. The further out of the money an option is, the higher its implied volatility. However, and this is where the interesting and valuable information lies, you can trade options in future contracts on future VIX levels, and the punch line, mathematically, overall stock returns have been observed to be negatively correlated with actual realized volatility and positively correlated with future implied volatility levels of indirection. I repeat, stock market returns have shown to be positive correlated with implied volatility levels and direction in the future.

With the term structure and implied volatility free and readily available on the CBOE website, an investor might want to follow the future structure of volatility months out into the future. I repeat, the level and trend in future month volatility, not what you see on the screen, not the spot index for volatility that people talk about on TV.

Now, listeners, trading VIX futures and VIX options can be incredibly difficult. I tell every new investor and trader I meet, don’t do it. Don’t even try it. Why? Well, I think I have pretty strong math and finance background. I graduated with highest honors in electrical engineering from Georgia Tech. I received an MBA from a top-ranked Business School in Boston. Listeners, I love math, I have all my life, I see equations and numbers in my head instead of sentences and words when I think, and even with that, I almost never trade options. I don’t ever trade options on volatility, why?

Because the best math minds in the world with the fastest computers in the world with real-time order flow taken directly from Robin Hood, and TD Ameritrade, and Charles Schwab, and everywhere else they can get it. All these people sit in Chicago and New York, on the Citadel securities trading desk, and they are 10 to 100 times smarter and faster than I am at math. These people are the rocket scientists of quantitative trading and they are smarter and faster than I could ever dream to be. Trading these options products.

is like sitting at a roulette wheel for a day or a week in Las Vegas and thinking that over time, you’re going to beat the house at the casino.

Listeners, there is a reason Ken Griffin of Citadel investments is one of the richest people in the world. He and his team of data scientists are smarter and faster than the rest of us at this game. My advice to listeners if you want to lose a bunch of money over time, go ahead, trade options on your pc or your phone app remotely from Starbucks over their Wi-Fi, while all the pros trade their systems off their colocated servers with their trading exchanges. Less I digress. Here’s where I stop giving away my secrets and point listeners and clients to a 12-month chart on future volatility.

For this specific observation. I’ve taken the three-month forward volatility contract, which right now would be for mid-June. Listeners. I know you can’t see this chart but trust me when I say there’s nothing in this chart since April of 2020 that says that three months from now volatility will be rising. The overall trend for over a year since April of last year at the height of COVID is down. It is a trend of lower volatility not higher volatility. In April of 2020, three-month future volatility stood at 40. Today it sits around 22.5. Listeners, what do momentum investors say? Well, they say the trend is your friend until it isn’t.

If you can, go to the CBO website and chart it for yourself. You’ll see what I see. This is the chart of volatility that you should be interested in not the spot VIX that people quote on TV, which you can’t trade, and it’s constantly talked about. The spot VIX does not have any relevant information in it for trading and investing in stocks beyond 30 days. Lower trending implied volatility over time is great for stock prices. And while we expect one more bout of higher implied volatility, probably in late June, we would expect to be using this increase in implied volatility as a buying opportunity.

The next time some supposed market expert or hedge fund manager on TV talks about volatility being so high and remaining so, ask yourself, what are they actually talking about? If they mention the subject of volatility, is it realized volatility that you see going across your screen every day? This is highly random volatility. It tells you next to nothing. Or are they talking about implied volatility that actually does have predictor powers in demining overall stock market direction over time? Think about that thing and then in your spare time, go check out the CBO website. Pull up some real-time quotes and check out charts in future volatility then go make up your own mind. As for the markets, the investment team at Oak Harvest is already looking at to better position for the second half of 2021. We’re looking for companies that investors should be looking at with a glass-half-full attitude come the second half of the year.

Troy and I should be doing a YouTube video pretty soon to get out to our clients to get them caught up in some of our new single-stock thoughts. After July 4th and no later than probably Labor Day this summer, big investors will once again be looking forward, they’ll be looking out to the second half of 2021 and all of 2022, and what are they likely to see? They will see that higher secular growth companies peaked way back in the third quarter of 2020 and that they stalled for almost a year, their valuations have compressed. Now they look cheap versus your long-term growth and free cash flow profiles. Big investors who’ve been chasing and pushing up value stocks since July of 2020 are likely to start asking themselves, “Am I paying [unintelligible 00:11:48] in 2022 for these cyclical names?” At Oak Harvest, we are comprehensive wealth management and financial planning advisor located right here in Houston, Texas. Give us a call if you want to speak to an advisor and have them help you craft a financial plan that is independent of the volatility of the stock markets. Our phone number here in Houston, 281-822-1350. We are here to help you on your financial journey through retirement with a customized retirement planning. My name is Chris Perras, Chief Investment Officer at Oak Harvest here in Houston, Texas. Have a great weekend.

Disclaimer: All content contained within Oak Harvest Podcast expresses the views of the speaker and is for informational purposes only. It is based on information believed to be reliable when created. Any cited data, indicators, statistics, or other sources are not guaranteed. The views and opinions expressed herein may change without notice. Strategies and ideas discussed may not be right for you and nothing in this podcast should be considered as personalized investment, tax, or legal advice, or an offer or solicitation to buy or sell securities. Indexes such as the S&P 500 are not available for direct investment. Your investment results may differ when compared to an index. Specific portfolio actions or strategies discussed will not apply to all client portfolios. Investing involves a risk of loss and past performance is not indicative of future results.