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The calm before the (next) storm?

Options markets suggest investors shouldn’t forget about defensive investments.

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August 13, 2020 | 6 minute read

The dog days of summer are upon us. While August has historically brought volatility to markets, equities in 2020 appear to have shrugged off their typical late-summer doldrums, posting solid gains to start the month. However, some warning signs are flashing of possible bumps ahead. In this note we discuss what the options market is telling us about potential volatility in the coming months – and what investors can do now to prepare.

Historically, August has been a tough month for stocks. The average S&P 500 return in August over the past 15 years is -0.17%, and these meager returns are often accompanied by an increase in volatility. But equities have looked tame lately, with 1‑month realized volatility clocking in at just 10.2%, and the average daily move of the S&P 500 over that time period has been just 30 basis points. This market would feel extremely placid even under normal economic circumstances, let alone our current macro backdrop.

S&P 500 rolling 1-month realized volatility

Source: Bloomberg, November 30, 2017–August 10, 2020.

Markets are just a few months removed from the acute pain many experienced during March’s sell-off, when realized volatility reached 92%. As markets have recovered in extraordinary fashion, volatility has receded. But year to date realized volatility remains high from a historical context, at 41.35%, whereas long-term averages are in the mid-teens. With headline risks extreme – a pandemic, a looming U.S. presidential election and geopolitical tensions, to name a few – markets feel downright complacent. The dichotomy between implied and realized volatility measures would agree, as these signals in options markets are pointing toward heightened volatility ahead.

Key takeaways:

  • Markets have felt complacent recently, but signs in the options market point to equity volatility ahead.
  • Both the VIX curve and the spread between implied and realized volatility indicate expected levels of heightened near-term volatility.
  • Investors should act now to position portfolios accordingly; many liquid alternatives are compelling diversifiers.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Beth Anne Byrne

Liquid Alternatives Investment Specialist

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