Tuesday, July 31, 2007

The SPX:VIX Ratio, the Mean Reversion Magnet, and Fun With Numbers

During all the excitement of the past week, quite a few indicators printed extreme readings. One that was all over the press was the surge in new lows. Babak, Dr. Brett and Headline Charts did such an excellent job of covering this one that it hardly seems worth noting again here.

Another indicator to print extreme readings that I’m sure I follow much more closely than others is the ratio of the SPX to the VIX. I’ve written a fair amount about the SPX:VIX ratio in the past and am of the opinion that the 10% trend line (for an explanation of the 10% trend line, try “The SPX:VIX Relationship”) acts as an intermediate to long-term mean reversion magnet.

One interesting aspect of the ratio is that it does not specify which of the variables will mostly likely be responsible for moving the ratio back toward the historical trend line. Given that the VIX is much more volatile than the SPX, it is natural to assume that the VIX will make the sharper move, so with an SPX of approximately 1500 and a SPX:VIX ratio of 115 or so, this implies a VIX of 13.04. One interpretation of this calculation is that the VIX is approximately 50% ‘too high’ for the current level of the SPX. Of course, another possible interpretation is that the VIX has been ‘too low’ for much of the baseline period.

Another way of looking at the ratio is to fix both the ratio and the VIX and solve for the SPX. Assuming a VIX in the neighborhood of the current 20 value and a SPX:VIX ratio of 115, this projects to an SPX of 2300, which stretches the limits of credibility a little too far for my taste.

So…if you believe in a relatively constant long-term relationship between the VIX and a trending SPX and all the assumptions that go along with it, which of the two scenarios is more likely to bring the SPX and VIX back toward an equilibrium: an SPX of 2300 or a VIX of 13?

For the record, I do believe in the trend line magnet properties of the SPX:VIX ratio, but I am quick to note that the mean reversion magnet sometimes exerts a sufficiently weak influence that the ratio can stay out of balance for several months to at least two years, as was the case during 2002-03. As unlikely as it may seem in the context of continued volatility in today’s session, the odds favor the SPX:VIX ratio being back in the 100-120 range in the next two months – and this sets up a number of potentially interesting trades.

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