The combination of disasters and the media that feed into them seems to create a feedback loop that often teaches the wrong lessons.
Many people were greatly affected by Hurricane Sandy, of course, and my heart goes out to them. But after my family prepared all weekend, all we got was some wind and a bit of rain overnight.
It will be interesting to see what people do with the next warning. Many do not properly prepare for foreseeable disasters. They see the alerts but remember previous warnings that turned out to be overblown--and that can create a situation that is truly dangerous.
Traders and investors can fall into the same trap. And we aren't talking about " black swans "--outlier events that are not foreseen, such as the 1987 crash and the 2010 "flash crash." Instead, traders can get lulled into complacency even when the risks are known, as in the case of looming debt ceilings and fiscal cliffs. These people dismiss dire warnings in the media as perma-bear doomsaying.
As for me, I see potential downside risk, and a fair amount of it. Viewed through this lens, these are times that can be easiest to exploit with smart trades.
Volatility tends to be low even as we approach a given macro event, as we now see with the approaching fiscal cliff. At the end of the year we face some serious issues that the government may or may not deal with in an appropriate and timely manner, but my sense is that most people are not terribly worried. (See related column, " A lack of fear in volatility index ")
Maybe they believe that the government is just talking, as was the case with the debt-ceiling issue. Or maybe they believe the Fed will be there to rescue us no matter what. But even at 18 the VIX is relatively low, and the term structure is quite flat.
Perhaps it is just my pessimistic nature, but this is one of those times that I will hope for the best and expect the worst. So I will tailor my longer-term hedges accordingly, staying long volatility in such a way that I can profit if the market moves either higher or lower. (I will lose money--a limited, pre-determined amount--if the market doesn't do anything.)
Although I do think it is likely that the fiscal issues will be worked out, I also believe that a negative outcome would have a dramatic impact on the market. And the subsequent downside in equities would be a lot larger than the potential upside should things work out fine.
Which brings me back to those low volatility levels. Right now protecting against the downside is relatively cheap.
It still has a cost, as does any insurance, but when I went for supplies before the hurricane there were people who would have paid just about any price for water and batteries. And if something bad does happen, that is how people will feel about protection at the time.
(A version of this article appeared in optionMONSTER's Options Academy newsletter of Nov. 1.)
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