Black swans are the most terrifying creatures if you invest your money in capital markets. If you want to know more about black swans, you can read our earlier post here.
Black swans can creep up on you at any time and lay waste to your years of hard-earned profits and capital. It would be useful to know where they lurk so that we can try to avoid them. It may not be 100% fool-proof but at least it's better than nothing.
Whenever a black swan strikes, the VIX will spike. This is because market participants panic and rush to buy protective put options. This pushes up the premium for options which in turn pushes up the VIX. Therefore, a clear indication of the presence of a black swan is a VIX spike. Hence, we can look back at the VIX history to locate instances of significant VIX spikes. This will give us a clue about the kind of environment that black swans tend to strike.
Below is a scatter plot of the intraday moves of VIX following each close the previous day. The move is measured from the VIX close to the highest point during the following trading day.
Large intraday VIX moves can happen across all volatility regimes but out of all the daily samples of VIX data going back to 1990, there were only 3 significant outliers in terms of intraday spikes.
The Shanghai crash and Volmageddon occurred when the previous day's VIX close was below 20. These are periods considered low-vol regimes. Although the VIX spike during the mysterious S&P 500 "Flash Crash" happened after the previous day's VIX close was 28, it also happened after a prolonged period of a low-vol regime.
There are good reasons why large VIX spikes tend to occur during low-vol regimes. Firstly, it doesn't take much to have a large % increase from a low base. Secondly, when few people are prepared for bad things to happen, more people will be caught by surprise when it actually does. This will lead to a huge demand for puts by people looking for last-minute protection. It doesn't mean that all low-vol regimes will lead to a black swan event, but black swans feed on complacency.
Conclusion
Big market moves can happen anytime so a diversified portfolio is still key to maintaining low portfolio volatility. However, those devastating moves that can seriously cripple a portfolio tend to occur during low-volatility regimes. This is especially important if you are also trading volatility in your portfolio. It is when markets are calm that we need to be careful not to overextend or take on excessive risk. The natural habitat for black swans is low-volatility regimes.
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