Larry McMillan on a Positively Correlated VIX and SPX

Thanks to the CFE’s Futures in Volatility newsletter, I have a fairly good idea what Larry McMillan is thinking about vis-à-vis a positively correlated VIX and SPX. The May 21, 2007 issue of Futures in Volatility just arrived in my mailbox a few minutes ago and in it McMillan makes the following observations:

“The last few weeks have seen a slow but steady rise in VIX (and in most VIX futures), even though the broad market, as measured by the S&P 500 Index, is rising in price. This is not a phenomenon that is seen too often, but it is not completely unprecedented. Occasionally, one sees a day or two in which VIX rises while the broad market rises, but it is much more unusual to see a trend of that sort. The current trend has lasted one month, but back in the 1990s, there were periods when VIX rose for months while the S&P 500 Index rose as well. If one recalls, VIX was near 10 in late 1994. But during the bull market of the 1990s, VIX rose to the point where it was routinely between 25 and 30 in 1998 and 1999. Yet, during that time, the S&P 500 Index also rose quite strongly, as those were the banner years of that bull market.

In the last month, futures prices have reacted accordingly, although their pricing curve is in a state that has not yet been seen in the 3-year history of VIX futures trading. Most of the VIX futures, Variance futures, and VIX options have followed VIX higher in the last month. VIX products have increased in price much across the board: November 2007 and February 2008 VIX futures are now slightly above 15. Even the August 2007 VIX futures are nearly 15. Does this mean that volatility traders are looking for higher volatility later this year? It certainly seems that way. What is a bit unusual is that there is not really much of a spread between the longer-term contracts…Looking back over the history of VIX futures trading, there are only two other occurrences of similar tightly-packed groupings of VIX futures prices. Those occurred in April and May 2005, and June and July 2006, both of which were times when the market had just fallen and was beginning to rally, so the futures were transitioning between “bearish” and “bullish” shapes. That is not the case now. This is the first time we have seen this construct while the market is rallying. In all likelihood, the futures are indicating that the market is going to become more volatile, regardless of the direction of the S&P 500 Index. It appears that traders expect volatility to be more in line with historical norms (the long-term historical volatility of the S&P 500 Index is approximately 15%).”

McMillan’s remarks dovetail nicely with my thinking in “VIX Futures: The One Picture to Remember” (see the comments, in particular.) Still, I am not yet prepared to make a call on the likelihood of increasing volatility or the direction of the SPX. As far as I’m concerned, the record highs and continued upside momentum in the SPX outweigh any signs of technical weakness or a breakdown in investor sentiment. I will have more to add to my May 4^th “Predictive Value of SPX and VIX Correlation: First Pass” post in the near future. This time around I will offer only two words of advice: trailing stops.