The VIX Is Cheap – Is It Time To Buy?

In the search for value among various asset classes, it has been concluded that -- generally speaking -- stocks are fairly to slightly overvalued, bonds are extremely and historically overvalued, commodities in general and gold in particular, while not cheap by historical standards, could be ripe for a playable rally, and that real estate is no longer cheap.

However, it was found that "volatility," or more specifically, volatility premium (aka the VIX) does appear to be cheap when looking at the big-picture.

For starters, let's define what the term, or in this case, the asset class of "volatility" means.

According to Investopedia, "The Chicago Board Options Exchange (CBOE) Volatility Index shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward-looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge.'"

The first thing to understand about "Vol" is that it really isn't a thing.

Related Link: Searching For Value (And Finding It) In The VIX, Part 1

Nope, the CBOE Volatility Index is simply a measure of expected volatility in the market. Right now, the expectations for market volatility are at very low levels.

The chart below shows the VIX on a monthly basis for the past 25 years.

CBOE Volatility Index (VIX) Monthly from 1990

As the red circles indicate, the current levels on the VIX are exceptionally low and on a monthly basis, are near the levels seen in 1994 and 2007.

The second key point to this Tuesday morning missive is that just because an asset is "cheap" doesn't tell much about when it might go higher. To ensure that there is no confusion, the current level of the VIX does not in and of itself mean it will rally furiously any time soon. The current levels just mean that one should expect volatility to spike higher at some point in the future.

Volatility Primer - Fear Is A Good Thing

Although it is a bit of a misnomer, the VIX is often called the fear gauge. However, this is one of those chicken-or-the-egg situations as traders often look to the VIX for clues about what might happen next in the market. Yet the bottom line is that expectations for volatility (the VIX) increases as fear increases, and not necessarily before.

The chart below shows how the expectations for volatility tends to spike around crisis events.

CBOE Volatility Index (VIX) Weekly from 2009

This weekly chart of the CBOE Volatility Index makes it clear that when crises hit, volatility tends to spike -- sometimes a lot. For example, the left side of the chart is the tail end of 2008, a time when the credit crisis was raging and fear was at historically high levels.

To put the magnitude of the fear that was in the market during this crisis into perspective, look at the monthly chart again and note that the 2008 spike was more than 50 percent higher than anything seen prior.

Also note that the monthly chart illustrates the VIX on a closing basis. During the crisis of 2008, the VIX spiked to almost 90 (the very top of the chart) on an intra-month basis -- yikes!

Related Link: Are Stocks Really Overvalued?

As one can plainly see on the weekly chart just above, the VIX surged by more than 130 percent during the first go-around with Greece in 2010 and again in 2011. Then the index has made several moves of 50 percent or more in the last five years. So, being long volatility via something like the iPath VIX Short-Term ETF VXX at the right time can be very profitable.

PLEASE note that ETFs such as VXX and VIXY are SHORT-TERM TRADING VEHICLES ONLY and SHOULD NOT be used as an investment position!

A New Era?

Another important takeaway from the weekly chart of the CBOE's VIX is that expectations for volatility have been quite low since the beginning of 2013.

Some analysts even argue that the market has now entered a "new era" of low volatility in the market. 

The next chart shows the CBOE Volatility Index on a daily basis over the past 18 months.

CBOE Volatility Index (VIX) Daily

If one were to look only at this chart, they would likely conclude that the VIX tends to trade in a range. As such, employing a "ride the range" strategy (buy the low end of the range and sell the high end of the range) looks to be a no-brainer.

For example, buying whenever the VIX hits 12.50 and then selling a portion over 16 appears to be a profitable approach.

However, the big problem with this tactic is two-fold. First, trading ranges can change. Second, when this particular asset moves, it moves very fast, as double-digit gains or losses in a single session are quite common (for example, the VIX spiked up 32.2 percent on July 17 as traders began to panic over the Russia/Ukraine situation). As such, being on the wrong side can be very painful.

But... The Rubber Band IS Stretched!

The final point to take away from this exploration of the VIX is that this is the third longest streak in the last 25 years (688 days, to be exact) without a spike of 100 percent or more in VIX.

Related Link: How Does An Investor's Opinion Affect The Market?

Think about that. Over the last 25 years, there have only been two other occasions where the VIX didn't at least double at some point. For reference purposes, the other two periods of low volatility environments were 1990 through 1994 and 2003 through 2007.

The Big Finish

And now for the big finish. The key is to recognize that, in the past, whenever the market has experienced a long period of low volatility, a spike of 100 percent or more has followed and that being "long vol" has been exceptionally profitable.

Another way to look at this is that periods of low volatility tend to be followed by a return to a high volatility environment. Therefore, investors may want to be ready to jump into some "vol" the next time something strikes fear in the hearts of traders.

But please, please, please remember: Buying and holding an ETF like the VXX, VXZ, or VIXY can be hazardous to your portfolio's health due to the decay that occurs in these vehicles.

Thus, the best way to play this game is to patiently wait for some fear to present itself and then to jump on board the move - quickly. Oh, and then you will need to be ready to jump out of the move at the drop of an algo -- unless of course a new crisis is actually developing, that is!