When volatility comes
The unusual calm on the Street may change anytime. Be prepared to deal with the market when it takes a southern turn

It could come as a surprise to many that the Nifty has not seen a three-digit correction in the last seven months. The index’s worst fall came in mid-May, when it almost touched three digits, shedding 96 points. This essentially shows that even a one percent correction in the index, common even in raging bull markets, has become rare in this calendar year.

In short, the equity market has been going through a phase of extreme low volatility. India Vix, a gauge of volatility in the Indian market, is now at a seven-year low. And the Vix graph has been seeing a progressive decline, except for occasional spikes that hardly last three sessions. This low volatility is not exclusive to the Indian market. Globally, volatility is at its lowest. The global volatility, as measured by CBOE Vix, is now close to a multi-year low.

The low volatility has brought a phase of complacency in the global market. The world over, investors are using short-term corrections to buy into equity assets. Flows to the equity markets show no signs of a decline.

Google search trends can be illustrative. Online search from India for the term volatility has hit almost rock bottom in the last one year while the search for ‘Nifty’ has gone up three-fold. Globally too, the search on ‘volatility’ is extremely low. That means fewer people are now interested in knowing about volatility as the term no longer bothers them.

But this phase of low volatility cannot last for too long, given that the global economies are not in the best of health. True, the US economic recovery has gathered a strong pace. But other major economies like China, Japan, Europe and most commodity-dependent emerging markets still see patchy growth. The US Fed’s recent attempt to pacify the market within days of sounding aggressive on rate cuts shows even the strongest central bankers are not sure of the global economy's direction. So volatility is bound to come back, and in force, but no one knows when.

The trouble is, if volatility returns when a market is scaling new peaks, destruction of wealth could be enormous and crippling for a large section of investors. So it is important to read the signs of volatility now, more than ever.

Three aspects of volatility have to be discussed here. First, when is it likely to strike? Second, what are the early indicators to look for?” Third, how to deal with volatility after it strikes?

Volatility happens when there is a change in direction, especially of fund flows. Global flows change their direction for various reasons—a change in the economic trend in large economies, or any other asset class becoming more attractive, or fear of overvaluation in troubled assets, anything could trigger a course change in flows.

Flows to emerging markets are pretty robust now. Today, every global investor/fund is keen to own emerging market assets, either directly or through exchange traded funds (ETFs). Billions of dollars are sitting on the sidelines, looking for investment opportunities. This huge pile of money is the most vulnerable to change in direction. The experience of 1997, when the Asian market crisis erupted, or 2008, when the global financial crisis exploded, shows emerging market ETFs and other direct investors first reduce their exposure to the equity market, as they are worried about currecny depreciation wiping out their gains, more than the decline in stock values.

An aversion to currency risk is the first indication that high volatility is on its way. The current phase of upward movement in global equity markets started in end-2016. But signals of an uptick had started from September 2016 onwards. Since then, despite the fall in equity markets, currencies of emerging market has been doing well. In early 2016, only a handful of currencies, like the Indian rupee, were able to do well against the dollar. However, from September, more and more emerging market currencies have been holding firm against the US dollar and the euro.

If emerging market currencies fall against the dollar for no apparent reason, it can be assumed that trouble for equity markets is not far behind. Investors should track the performance of the dollar index to assess the trends in currency markets. Essentially, one has to check out how far the dollar is gaining against various emerging market currencies. Overlaying the charts of US dollar and the rupee would show that the rise in the Indian equity market has coincided with a relatively stronger rupee. So, if the rupee caves in, the flows may start to thin down, leading to stock volatility.

Now comes the issue of dealing with volatility. There are ways for investors to use volatility to their advantage. But this is not an easy task and requires some hard work to learn about the use of derivative instruments.

An understanding of various derivative instruments and strategies will help one to hedge long positions in stocks through put options—of both indices and individual stocks —when the market turns south. The times like these, when the market is calm, is ideal for fresh entrants to the stock markets to learn about derivative instruments and use them to hedge against currency risks rather than use them as mere instruments of speculation. The Internet and the websites of stock exchanges offer plenty of learning materials on derivative instruments.

Getting a handle on hedging will make dealing with volatility easy. Volatility does not mean the end of market opportunities. One can deal with it clamly and with poise when panic strikes the market. That's the magic of hedging.

rajivnagpal@mydigitalfc.com

(Rajiv Nagpal is consulting editor, Financial Chronicle)

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