Friday, December 21, 2007

The Incredible Shrinking VIX

Santa Claus didn’t quite deliver the expected rally this year, but at least we got the incredible shrinking VIX. I have talked about the absence of fear on several occasions, most recently on Wednesday, but the sinkhole in investor fear has continued to expand since then. Today’s fall in the VIX all the way down to 18.65 means the lowest low water mark since the first day in November, when the VIX traded in the low 17s.

I believe Rob Hanna of The Money Blogs was the first to comment on the unusual phenomenon of the VIX following the markets down. While Rob was cautious about the negative implications of this phenomenon on the broader markets, Brett Steenbarger at TraderFeed was more open about the likelihood of an impending period of ‘subnormal short-term returns’ indicated by his research in Stocks Down, Option Volatility (VIX) Down: What Happens Next.

Adam Warner of Daily Options Report has required a little more confirmation to believe that the drop in volatility is something more than the vagaries of the holiday trading calendar, but in Volatility Dippage, it seems he has finally come around to the point of view that the VIX drop is real and not a calendar-driven oasis.

I agree that the drop in the VIX is real, but not to the extent that the VIX suggests. Here is a perfect opportunity to use the VXV, which measures volaltility 93 days out instead of the VIX's 30 day window. Per the VIX-VXV ratio chart below, the expectations of volatility over the next 30 days (VIX) are dropping much faster than those over the next 93 days (VXV). Further, if you look at the VIX futures quotes, you can see that future volatility expectations are pretty much flatlined out through the November 2008 contract, with the VIX contract prices all currently hovering in the 23 range. The bottom line: fear may be slipping a little, but it is not in a free fall, as the VIX might lead some of us to believe.

I will close with a link to a post from May in which the title tells the story: High Positive Correlation Between VIX and SPX Often Signals Market Weakness.

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