On Wednesday, May 17, the markets were hit with a massive volatility spike. The VIX, or what many like to call the “fear gauge,” jumped 43%. It was the seventh highest move of all time (in terms of percentage), and it was largely unexpected, as most of them tend to be.
Just last month, we saw a big move down in volatility after the first French election. Since then, the VIX stayed stubbornly low. In fact, it fell under 10% last week, something that had not been seen in more than a decade. Low volatility became the story du jour for business media outlets.
Why a volatility spike is a great buying opportunity
So what happened after the volatility spike? Volatility fell right back down. For years, that has been the pattern. Human behavior rarely, if ever, changes suddenly, so I prefer to follow these patterns until they do change.
Since the financial crisis ended, markets have largely been in a bull trend. Lower volatility in markets has been persistent since the Fed stepped into the game back in 2009. Take a look at the VIX chart since mid 2013, and you’ll see that big spikes up in volatility have been followed by drops.
Zooming in a bit further, as I did with the chart above, and you’ll see that these big volatility spikes accompany “momentary lapses in reason,” aka, the decision to bail out of stocks (always at the wrong time). But that is the herd mentality and it is why contrarian thinking usually offers the highest probability play. In other words, go against the crowd – and make money doing it. When investors decided to exit their trades (evident by the many circles at volatility spikes), it is actually a great time to step in and buy.
How easy is to be a buyer when everyone’s hair is on fire? It’s not, but as history proves, it is often rewarded. Will there be a time when “buy the dip” does not work? Of course, but until then, the best course of action is to follow the established pattern. Again, look at the chart. How many volatility spikes lasted long? None. And how many led to a higher market? Every single one.
The recent spike on Wednesday was sharp and scary indeed, but volatility retreated in a hurry. Markets rose in kind, as expected when the VIX falls. While the ideal reflex was to buy into the hail storm on that day, note that even waiting a day or so for the dust to settle was just as good. Remember this pattern down the road, as we will no doubt encounter more high volatility spike situations. Use them to your advantage.