A steady rally in stocks and the euro this year has led to a sharp drop in the main measure of financial market swings - volatility - and many analysts say this could be an ideal time to buy protection against a sudden reversal.A flood of cheap European Central Bank cash in late December, and the promise of more, dampened earlier price swings and pushed shares higher.But the rally has been in low volume, suggesting investors, mindful of the unresolved euro zone debt crisis and still tentative global growth, do not think it will last.“The next volatility spike is coming... Whatever the source, there will likely be a catalyst at some point soon. The real problem is going to be timing that,” Simon Carter, European head of options strategy at Deutsche Bank, said.“These lulls in volatility are to some extent misleading as the crisis isn’t over. Lower volatility is an opportunity to put in place some protection.”Investors can protect themselves against price swings by buying options - essentially bets on which way and how far assets will move. They can also speculate on the same, trading the expectations of volatility implied in options prices.The Euro STOXX 50 has rallied strongly but steadily since the turn of the year, up 6.7 percent, while the Euro STOXX Volatility index is down 12.5 percent at 28, less than half last year’s August peak and far below the 87.88 high hit at the height of the financial crisis.In the United States, volatility on the Standard & Poor’s 500, measured on the VIX index, is at 18.6, from a 2011 high of 48 and a peak of 89.53 after Lehman Brothers collapsed in 2008.In currencies, too, implied volatility has fallen, with euro/dollar 1-month volatility at 11 percent, down from 18 percent in September and a third of post-Lehman levels.All this looks overdone to some analysts, especially as bond markets remain cautious, highlighted by flows into the safest government debt and still elevated peripheral euro zone yields.
JPMorgan options analyst Arindam Sandilya said the drop in currency market implied volatilities, or vols, had gone too far.“Currency vols flatlined in the face of continued gains in global equities and an across-the-board narrowing in risk premia, indicating that their massive compression since mid-December represents an overshoot,” he added.Indeed, the FX options market is showing a growing preference for selling euros.FUTURE SWINGS Carter at Deutsche Bank said future swings in asset prices could be far sharper than investors are used to.“We’re in a growth sensitive world where investors will remain nervous,” he said, with periods of “surprisingly low” volatility accompanied by higher spikes.As long as a disorderly Greek default could be avoided, Euro STOXX short-dated volatility was unlikely to go much higher, although any contagion to Spain or Italy could push it back to the high 30s.If that in turn hit global growth, VIX volatility could spike to the 30-40 range, while with an event such as the euro breaking up “volatility spikes to 50, 60 or even higher, are easily possible”, Carter said.Previous stock rallies have usually been accompanied by a rise in long-dated U.S. yields. This time long-term yields have not risen. Instead, they are pinned down by expectations of more stimulus by the Federal Reserve and the ECB.To some, this is evidence the risk rally has been built on shaky foundations and reason to snap up protection or place a bet on volatility as an undervalued investment.For Guy Stern, head of multi-asset fund management at Standard Life Investment, and who helps run 11.5 billion pounds ($18.1 billion) in Standard Life’s Global Absolute Return Strategies (GARS), the VIX is too low.“There are things that should be causing heightened levels of volatility, just in general, and so if I see a price this low, it feels like a good time to buy it.”