Volatility May Increase in 2014

The U.S. economy has greatly improved since the peak of the financial crisis with the financial markets recovering all losses and rising to record all-time highs. The $85 billion asset purchase program expanded the monetary base by trillions of dollars in just a few years, has contributed to the financial enthusiasm.

The real recovery hasn’t been as strong, however; GDP growth has been mild and the job market has yet to fully recover. Many investors and analysts alike believe that as soon as the Fed cuts back on the asset purchase program financial markets will experience severe declines and become more volatile.

In December 2013, Ben Bernanke announced a $10 billion monthly cut to the asset purchase package. The Fed made a second cut in January. If the markets weren’t affected by the change in December, it seems the same isn’t true of the January reduction. After a strong performance of nearly 30% posted by the S&P 500 in 2013, investors are now much more cautious about the future, waiting for clues that companies are truly expanding their earnings to justify the higher valuations given by strong price increases.

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The year 2014 started with the S&P 500 in decline and economic reports showing some weakness. That is the case with the latest nonfarm payrolls reports, which have been disappointing.

While payrolls rose at a pace of 194K per month during 2013, the pace decreased to 154K over the last 3 months. The announced numbers for December and January were far below expectations and may indicate a global weakening of employment conditions.

At the same time, emerging markets have been experiencing great volatility, mainly because foreign investors are reducing their exposure to these countries and exchanging their funds for the safety of the dollar. Even if we can’t point to an emerging markets crisis at the moment, we should be cautious about the future. Investors should be prepared for an increase in volatility, which is a highly favorable scenario for trading in options.

The VIX index, often used as a gauge of investors’ fear and as a measure of volatility, increased substantially in January, hitting a level near 21. As investors found the recent sell-off in equities more as a buying opportunity than as the end of the bull market, the VIX decreased to the current level of 15.3. We believe that economic conditions will push the index higher again.

Traders can profit from the volatility increase by buying call options on the VIX index or by engaging in some volatility strategies, as is the case of a straddle. By buying a call and a put option on the same asset, both with the same expiry date and strike price, the trader is betting the price of the asset will become volatile and either decrease or rise substantially, a situation that will result in a profit.

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