We should buy stocks because the VIX is going to decline, according to a strategist at J.P. Morgan. As reported in the Striking Price Daily:
"Admittedly, trading stocks, or puts and calls, to benefit from VIX’s fluctuations seems like adventurism, but many investors routinely chase less well-researched ideas. Lee, the J.P. Morgan strategist, opines that VIX can be expected to decline following improvements in the credit markets, more macroeconomic clarity, an easing of hedge-fund redemption related selling, and the end of the presidential election."
“In fact,” he advised clients, “we probably feel more strongly that the VIX will decline than we can see a short-term direction in equity prices.”
The analyst suggests buying stocks here that are negatively correlated with the VIX. Our first thought is that, over the long run, that’s probably a fine idea. And we couldn’t agree more that, unless some dramatic new news comes along, it seems likely that the VIX will be lower a month or two from now.
But if you think implied volatility will decline in the future, that’s not necessarily a reason to buy stocks; that’s a reason to be a net seller of options. Just because certain equities have historically been negatively correlated to VIX movement really doesn’t mean much, especially over the short term: it’s entirely conceivable that the VIX implodes while equities churn sideways or even drift lower. In fact, if indexes start trading in 1-2% daily moves again - rather than 3-6% - you’re almost guaranteed to see implied volatility fall in line with the lower realized volatility. In that scenario, those “inversely VIX correlated” stocks could continue falling a percent each day, while option sellers will reap their rewards more or less instantly. That’s not a recommendation to load up the boat on put spreads here. But if you “feel more strongly that the VIX will decline than we can see a short-term direction in equity prices,” it makes a lot more sense to express that view with some defined-risk option spreads than to go searching for stocks that will somehow rise because the VIX is falling.
The VIX may be everybody’s new bicycle, but it is not, after all, the cause of anything. While it may correlate with all sorts of fantastic phenomena, the nature of this index is such that it can’t be the cause of anything. If you see a bunch of stocks rising and the VIX falling on the same day, or even over a long period, rest assured that the causality only goes in one direction. Would you buy equities in size because J.P. Morgan says the VIX will decline? Maybe, sounds plausible, right? Would you buy equities in size because of the changes J.P. Morgan expects in a snapshot of a 30-day variance swap rate based on the SPX options? No? Well it’s the same damn thing.
