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In practice, falling volatility is a good sign for investors; sentiment is high, financial markets are steady, and equities tend to move higher. However, when is low volatility too low? On Tuesday, the CBOE VIX Index — considered the best gage of investor fear — traded to its lowest level since 2006, not surprisingly the same day the S&P 500 and Nasdaq Composite made all-time highs.
Normal Resting States
Some analysts' are wondering whether it's too good to be true. "I don't know what brings us out of the doldrums, but I do know this is not a normal resting state," Lloyd Blankfein, Goldman Sachs CEO told CNBC Tuesday.
This "normal resting state" has lasted a long time. On March 21, the S&P 500 fell 1.48 percent, ending a 109-day streak without falling by more than 1 percent on a closing basis. The longest such streak since September 1993, and the seventh longest of all-time. (See also: Low Volatility: The Calm Before The Storm.)
While the low volatility is posing concerns for some investors, it is providing opportunities for others. Those who are looking to hedge against a decline in financial markets or take an outright bet on the market falling, it has never been cheaper.
Calculating the price of a put option requires many variables; current price, strike price, and time to expiration to name a few. But only one factor in most option pricing models cannot be clearly observed: volatility. More specifically, implied volatility, which is the expected future volatility as opposed to historical or statistical volatility. As investors become less wary of a market sell-off, implied volatility falls, bringing the price of put options down, making it cheaper for investors to bet on a decline in financial markets. (See also: Options Basics: How Options Work)
Low Volatility Everywhere
It's not just equity markets that are experiencing record levels of low volatility. According to Reuters, G10 currency volatility is at a three-year low and U.S. Treasury market volatility is at an 18-month low. While passive investors are happy, traders are not.
So what's wrong with a boring market? One risk of excessively low volatility is in the advent of a shock when the market is positioned the same way it will create a rush to buy volatility, overextending any declines.
For those looking to hedge portfolios or bet on a fall, one thing will always remain true. It's not about being right, it's about being right at the right time. "The low volatility may be a bit of a bubble of confidence, but we won't know until we know," Blankfein told CNBC.