Volatility traders generally make trading decisions based on implied volatility and Implied Volatility Rank (IVR). However, that doesn't mean that volatility traders are blind to directional movement in a specific underlying or broader market indexes.
If you saw a headline saying the VIX had spiked 20% in one day, you would likely speculate that equity markets in the United States had decreased sharply. Or, if you read a headline saying that equity markets had been steadily grinding higher throughout the summer, you'd probably guess that the VIX had gone lower alongside them.
Looking at the broader US equity markets at the start of summer 2016, one can see that the S&P 500 is fairly close to all-time highs. Depending on your trading strategy, this may or may not affect how you construct your portfolio.
But for those that are more directionally-inclined, a recent episode of Market Measures may be of interest - especially given current market conditions. In the episode “High Risk | Buying Into Strength” hosts Tom Sosnoff and Tony Battista explore the risks of going long in a market that appears to already have summited the mountain.
The basis of their discussion is a study done by the tastytrade research team that examines “average” market behavior since 1990 when indexes are peaking. This analysis utilizes data from the S&P 500 (1990 to present) and tracks the number of days between the market closing at new highs.
One filter applied to the data sought to isolate the top 15 instances of the longest periods between all-time new highs. Looking at that group specifically, the average length of time between all-time market highs measured in at 447 days, as shown below:
The results show that the median drop from peak to trough when the market does correct was about 9.2%. The average drop was even more pronounced - roughly 16%.
Obviously, conditions that dictate the path of the market change from year to year. There’s no way to extrapolate the future return of the S&P 500 from the current market highs.
The most important takeaway, therefore, is highly dependent on your own customized strategy.
If your portfolio is currently overall long deltas, it may be worthwhile to ensure that structure jives with your bullish outlook for the broader market given the aforementioned tendencies when peaking.
If, on the other hand, your portfolio is more market neutral, you could ensure that risks to the upside and downside are proportionate to your expectations.
We recommend you watch the entire episode of Market Measures focusing on the risks of “buying into strength.”
If you have any questions, we hope you’ll follow up at firstname.lastname@example.org. We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.