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Historically, scheduled releases of market-impacting news, such as Federal Reserve meetings, quarterly earnings announcements, and other “known-unknowns” presented pre-determined times where stock market volatility might increase. Markets assigned a probability of an expected outcome to this news, based upon its significance and potential to move the market, and prices and risk tolerances were adjusted accordingly before the event. On release, if market participants accurately predicted the news, the market reaction tended to be muted but, if the expectation deviated significantly from the actual outcome, the market reaction could be severe.
Occasionally, surprise news items, often based on exogenous factors, which are not anticipated (“unknown – unknowns”) tended to have a more severe impact on market pricing, catching participants unaware and possibly wrong-footed from a risk perspective. Additionally, these events can mitigate the most advanced algorithmic programming and best technical analysis and cause rapid adjustments to volatility metrics.
This historical pattern has changed significantly in recent years, as more frequent “unknown-unknowns” are hitting markets, often caused by unprecedented Central Bank activity or tweets and announcements related to the ongoing trade war between the U.S. and China (among others). This new paradigm requires market participants adjust their strategies and adopt new tools to adapt to markets increasingly at the mercy of this “headline roulette,” where the next news headline could drastically change the near-term behavior of the stock market.
We view this as the “new normal,” and stock markets are finally beginning to discount this new reality. Recently, the baseline level of the VIX has moved higher in non-volatile periods versus a few years ago, which has offset some of the risks presented by this new source of volatility. More importantly, adjusting the structure and timing of positions can better insulate a portfolio from these negative shocks.
As an example, traders who utilize options in their portfolios can mitigate these new risks by reducing the time to expiration of positions held (duration). Decreasing duration significantly, even 50% or more, can exponentially decrease the impact from unexpected news. Expressed mathematically, an option’s sensitivity to volatility (known as vega), decreases rapidly as time to expiration decreases (theta), which correspondingly decreases the volatility risks (gamma).
Insulation from volatility can be found in other instruments, but the mathematical properties of options provide an empirical reason for their use as a defense against volatility, which can be a useful tool in dealing with “surprise” news flow and the resulting sharp market moves.
