The VIX: How Scared is Scared Enough?

By Paul Springer

Sometimes called the Fear Index, the Chicago Board Options Exchange Market Volatility Index (VIX) tracks the implied volatility of S&P 500 index options. It’s has been around since 1993, but futures and options on the index started trading in 2004 and 2006 respectively. Exchange-traded funds and notes have become available more recently.

The number associated with the VIX is a percentage reflecting an implied annual change in the next month. The VIX is directionally agnostic — the volatility could involve increases or decreases in the index.

Right now the VIX is around 20, near its all-time average. The Wall Street Journal wonders if that number is oddly low given the rampant uncertainties tormenting investors since the credit crisis.

“The effect is leading some investors to discount the warning signs of continued high unemployment and readings on the economic recovery that are mixed at best,”  the article says.

The VIX has a certain oracular quality that compels its worshippers to divine the meaning of the index’s numerical pronouncements. These interpretations provide different ways of reading the VIX tea leaves:

TraderPlanet sees the VIX going lower in an analysis that includes several other asset markets. A snippet:

Last seen the VIX was just below 20 after peaking in late 2008 just north of 80. The chart makes the case that major bottoms for the VIX tend to be associated with time periods when the index is trading below 15 for an extended period of time. If the VIX bottoms when copper prices are peaking then the argument would be that the current trend has some time left to run as money continues to shift away from the dollar and the stable consumer sectors and into currencies like the Brazilian real, Mexican peso, and Australian dollar.

SwingTrade Online says volatility is gone in the short- to mid-term timeframe, and the lack of movement can make for a bad mix with some investors’ psychology:

You’re not going to love this if you like ACTION . . . . Larger day to day swings are far less likely, thus, you have to find a way to be patient and understand the best way to play this market, which is to simply to find the best base set-ups and wait for them to make their move. Make sure you’re not buying bases that are either at the top, or are flashing overbought oscillators. . . Expecting big market swings, and then not getting them, can lead to a give-up mentality.

SeekingAlpha sees a correlation between investor complacency and Federal Reserve action:

But alas, the complacency or a lack of fear has returned this week. This is never a good thing, as the market seems to do better in climbing a “wall of worry.” But it’s also not a timely indicator of anything imminent, either. For now, market participants are simply enjoying the cozy, worry-free price action, supported by the Fed.

InvestorPlace senses a stock market pullback based on the term structure of VIX futures prices, which are shaping up in a scenario where “the market gods punish the imprudent for their hubris.”

By taking the difference between the near-term VIX and the three-month VIX, we get what’s known as the “volatility term structure” by Wall Street insiders. Don’t let the abstract language intimidate you: This simply measures the difference between near-term optimism and over-the-horizon caution. When this measure drops below 0.8, as it is now, it’s been a powerful signal of an imminent pullback for stocks.
In trading today, this indicator absolutely plunged as if someone hit it over the head with a hammer. The dramatic decline was partially due to technical factors as the VIX rolled out of October options contracts (which are high due to Q3 earnings) and into November contracts. But this doesn’t take away from the fact that investors are unprotected against market declines relative to future volatility expectations on a scale that hasn’t been seen since the bear market of 2007 got started.

OptionMonster also provides some term structure analysis courtesy of TradeMonster. This view says complacency fears are misguided, but investors could still be in for a surprise:

So the VIX isn’t really showing complacency, as some posit, because it remains 50 percent above actual volatility. And that doesn’t even account for those higher implied-volatility levels moving forward.

One concern in this environment comes from the volatility ratios, which hit a new low–by a long shot–in yesterday’s trade. These lows have largely corresponded with selloffs in equities, so this does raise a warning flag.

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