The New VXST and the VXST:VIX Ratio

At the beginning of the month several interesting announcements came out of the CBOE Risk Management Conference in Portugal. One which particularly caught my interest was the announcement of the launch of the new CBOE Short-Term Volatility Index (VXST), which is essentially identical to the VIX, except that whereas the VIX is looking ahead at a window of 30 calendar days, the VXST measures implied volatility of options on the S&P 500 index (SPX) for the next 9 calendar days.

This means that the CBOE now has three different indices to measure implied volatility expectations in SPX options:

• 9 days (VXST)
• 30 days (VIX)
• 93 days (VXV)

The VXV has been a favorite subject of mine going back to my initial comments on the index and the VIX:VXV ratio I pioneered as an indicator back in December 2007. With the new VXST, investors now have a better gauge of volatility expectations to apply to time frames that are appropriate for weekly options, which are on track to account for about 25% of all options trades by the end of the year.

The launch of VXST options opens up a whole new set of possibilities, not the least of which is a VXST:VIX ratio that offers some possibilities as an indicator that are similar to those of the VIX:VXV ratio. In the chart below, I have mapped not the ratio of VXST:VIX, but the differential between the two indices. With VXST historical data going back to the beginning of 2011, it is worth noting that the VIX has been higher than VXST about 61% of the time. Typically, when volatility spikes, VXST spikes much higher than the VIX, with the bulk of the 39% of the instances in which VXST is higher than VIX occurring mostly during periods of elevated volatility.

[source(s): CBOE, VIX and More]

I will go into much greater detail regarding VXST:VIX vs. VIX:VXV at a later point. For now it is worth noting that these ratios have some advantage to comparing the VIX futures term structure in that the indices focus on a fixed time period, while the days to expiration of the VIX futures is constantly in flux.

Also of interest, the CBOE press release notes:

“Plans call for CBOE and CBOE Futures Exchange, LLC (CFE®) to introduce VXST Weeklys options and futures. The launch dates for these tradable VXST products are yet to be determined, pending regulatory approval.”

As compelling as VIX products are for trading, I can imagine that VXST options and futures might be even more attractive to certain types of traders. Also, if VXST futures gain some traction, I can envision ETPs based on these that might rival the interest in VXX at some point.

In other words, this could easily turn out to be a huge development in the volatility space.

Related posts:

• Revisiting the VIX:VXV Ratio
• Weekly Options Coming on Strong
• Crazy VIX:VXV Ratio Chart
• The 2012 VIX Futures Term Structure as an Outlier
• VXV Heralding a Return to Normalcy
• Chart of the Week: VXV at Critical Juncture
• Take a Longer View on Volatility (Barron’s)
• VIX:VXV Ratio Moving Toward Bearish Zone
• Chart of the Week: VXV and Systemic Failure
• The VXV and Extreme Structural Volatility Risk
• The VIX, VXV and Volatility Expectations
• How to Create Your Own Portable VXV
• Thinking About VXV
• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting
• The VIX, VXV and Volatility Expectations
• The VIX:VXV Ratio

Disclosure(s): short VXX at time of writing; the CBOE is an advertiser on VIX and More

Revisiting the VIX:VXV Ratio

Two of my favorite bloggers, who hail from very different corners of the investment landscape, both happened to mention me in reference to the VIX:VXV ratio in the past few days.

On Wednesday, in A Buy Signal from the Option Market, Cam Hui of Humble Student of the Markets, noted that the VIX:VXV ratio had fallen below 0.92, where “it has provided reasonably good long entry points in the past.” Cam linked back to my first post on the VIX:VXV ratio from December 2007, which, I am fairly certain is the first time anyone ever mentioned the ratio and suggested that it might have some value as a market timing signal.

Today Russell Rhoads of the CBOE, whose Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes is undoubtedly the best book ever published on the VIX, also mentioned the VXV:VIX ratio in one of his weekly volatility columns, This Week in VIX Options and ETPs – 9/13/2013. Russell’s version of this ratio, VXV:VIX, flips the numerator and denominator, so his comments are the inverse of much of my analysis. “Note on the chart there are a few instances where the ratio of VXV to VIX falls below 1.0. That seems to coincide with a subsequent near term bottom in the stock market as well.”

I have literally dozens of posts on the VIX:VXV ratio going back to 2007 and while I have hand-picked a selection of posts below that focus on this subject, I could easily fill a book with data, interpretative overlays and trading strategy ideas based on VXV (essentially a 93-day version of the VIX) and its relation to VIX and other measures of volatility.

One of the more interesting issues related to the VIX:VXV ratio is how that ratio has moved up and down over the course of various volatility regimes. In the first two years of the ratio (2007 and 2008), the average (mean) ratio was 0.97 and 1.02; during the past two years, however, the average (mean) ratio has fallen all the way down to 0.87 and 0.90.

For about 1 ½ years following the launch of VXV, using absolute levels in the VIX:VXV ratio as bullish and bearish signals worked almost perfectly. One only has to look at VIX:VXV Ratio Moving Toward Bearish Zone to understand why it quickly gained so many fans. When the 2008 financial crisis hit and in the aftermath of the crisis, the VIX:VXV ratio began to look like just another broken indicator. Since that time, the VIX:VXV ratio has continued to be a very useful indicator, yet its value has been greater when studied in relative terms than absolute terms. Old rules, such as increasing long equity exposure when VIX:VXV fell to 0.92 or 0.90, proved to be of little help when the average of the ratio hovered around 0.90 instead of 1.00.

During the last two years, the VIX futures term structure has departed significantly from historical norms, as I have demonstrated in the likes of The 2012 VIX Futures Term Structure as an Outlier. Frankly, the 2013 version of the VIX futures term structure looks a lot more like the outlier 2012 data set than any previous year.

There are many ways to think about a ratio in relative terms. Using percentiles, standard deviations and short-term vs. long-term moving averages are just some of the ways that one can rethink the VIX:VXV ratio in relative terms. In the chart below, for instance, I have calculated the two-week moving average of the VIX:VXV ratio relative to the moving average for the past quarter. This keeps the data standardized around a mean of 1.00 and allows for a way to evaluate the ratio on a relative basis, regardless of whether the current volatility regime has depressed or lifted the ratio data for the full lookback period.  Note how extremes in this ratio of ratios has been an effective market timing signal over the course of the past eleven years.

[source(s): CBOE, VIX and More]

Given the scope of the issues that are related to VXV and the VIX:VXV ratio, I pledge to devote a good deal more space to these issues going forward, including the twists and turns in the VIX futures term structure, the use of the VIX:VXV ratio in determining the dynamic allocations for XVZ, etc.

For those who are doing some of their own research into these and some tangential subjects, the links below are an excellent point of departure.

Related posts:

• Crazy VIX:VXV Ratio Chart
• The 2012 VIX Futures Term Structure as an Outlier
• VXV Heralding a Return to Normalcy
• Chart of the Week: VXV at Critical Juncture
• Take a Longer View on Volatility (Barron’s)
• VIX:VXV Ratio Moving Toward Bearish Zone
• Chart of the Week: VXV and Systemic Failure
• The VXV and Extreme Structural Volatility Risk
• VXV Is One Year Old
• The VIX, VXV and Volatility Expectations
• How to Create Your Own Portable VXV
• Thinking About VXV
• VIX Sets Two New Records
• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting
• The VIX, VXV and Volatility Expectations
• The VIX:VXV Ratio

[source(s): CBOE, Yahoo, VIX and More]

Expanded Performance of Volatility-Hedged and Related ETPs

When I recently assembled Top Posts of 2013 (Through First Half of Year), several themes jumped off the page. The top four posts of the year summarize what many investors have been worrying about this year:

1. The Low Volatility Story in Pictures
2. Four Years of SPX Pullbacks in One Plot
3. VIX ETP Performance in 2012
4. All-Time VIX Spike #11 (and a treasure trove of VIX spike data)

The issues are related to pullbacks in stocks, the VIX spikes associated with them, how to minimize portfolio volatility when these types of events happen and what the implications are for various VIX exchange-traded products.

With that backdrop and a stock market that has been looking fatigued while it has meandered sideways for the past month, quite a few investors are thinking about how to hedge a portfolio that has a long-equity bias. In the graphic below, I capture the recent performance of a number of ETPs which may be suitable for hedging that type of portfolio.

[source(s): StockCharts.com]

Interestingly, the performance of these securities appears to fall into three distinct groups.

The top group has two ETPs:

• SPY (black line), included largely for reference purposes
• Direxion S&P 500 RC Volatility Response Shares (VSPY), which employs a market timing mechanism that dynamically allocates between stocks and bonds according to measures of market volatility (blue-green line)

The second group contains the core of the VIX-based dynamic hedging products:

• First Trust CBOE S&P 500 Tail Hedge Fund ETF (VIXH), which is essentially a portfolio consisting of 99-100% of SPY, augmented by a dynamic allocation of 0-1% of VIX options (light green line)
• Barclays ETN+ S&P VEQTOR ETN (VQT), which has a dynamic allocation of VIX futures that fluctuates based on realized volatility and the trend in implied volatility (red line)
• PowerShares S&P 500Downside Hedged Portfolio (PHDG), like VQT, has a dynamic allocation of VIX futures and is based on the S&P 500 Dynamic VEQTOR Index (dark purple line)

The bottom group includes two performers:

• UBS ETRACS Daily Long-Short VIX ETN (XVIX), which is equivalent to a fixed allocation of a 100% long position in VXZ, offset by a 50% short position in VXX. I have included XVIX (aqua blue line) here largely to show how closely the performance corresponds to that of XVZ
• iPath S&P 500 Dynamic VIX ETN (XVZ), utilizes the slope of the VIX:VXV ratio (SPX 30-day implied volatility to SPX 93-day implied volatility) to determine the dynamic allocation to short-term and medium-term VIX futures. In this case, the allocation to short-term VIX futures (think VXX) can be either long or short, while the allocation to medium-term VIX futures will always be long, though it is variable (fuchsia line)

Keep in mind that the most aggressive hedges are almost always the ones that underperform the most in bullish periods. If you want a very different look at how some of these products perform when stocks decline sharply, check out Performance of VIX ETP Hedges in Current Selloff.

The links below provide some background information on some of these products as well as performance data and should serve as excellent starting points for more comprehensive research.

Related posts:

• VIX ETP Performance in 2012
• Dynamic VIX ETPS as Long-Term Hedges
• Performance of Volatility-Hedged ETPs
• Performance of VIX ETP Hedges in Current Selloff
• Comparing SPLV and VQT
• Three New Risk Control ETFs from Direxion
• Cheating with Partial Hedges
• How to Insure Your Stock Portfolio (Barron’s)
• Why Not Point Hedges?
• Investing with a Target Volatility Approach

Disclosure(s): long VQT and short VXX at time of writing

Crazy VIX:VXV Ratio Chart

There was a point in the history of VIX and More that I gave serious consideration to a regular feature in which I unveiled “Strange and Unusual Charts” that presumably had, apart from their novelty, the ability to shine some new light on at least one corner of the investment universe. That being said, I have always had an affinity for presenting charts that show unusual ratios, non-standard time frames and such and while the likes of Chart Porn and Unusual Chart of the Month: VXO and RVX did get me started down a slippery slope, I never quite fell into the habit of tilting wildly at windmills on the plains of StockCharts.com and their brethren.

One rabbit hole that I was definitely the first down and pursued the most aggressively was the VIX:VXV ratio, which one blogger insisted was sure to ultimately be my investing legacy. In all fairness, for the first year following the launch of VXV (essentially a 93-day version of the VIX), the VIX:VXV ratio performed as if it was going to make all other indicators obsolete. Of course, then the financial crisis of 2008 hit and the ratio began sprouting warts all over. While I talk about the VIX:VXV ratio only rarely in this space nowadays, the general idea of which the VIX:VXV ratio is just one instance of what has become one of the main themes of this blog: the idea that an understanding of the VIX futures term structure is critical to understanding the valuation of and trading opportunities available for all VIX products, including futures, options and exchange-traded products.

All of which brings me – somewhat belatedly, perhaps – to today’s chart, which is right out of the same cauldron that produced some of the curiosities of yesteryear. The chart below captures 2 ½ years of daily bars in the VIX:VXV ratio and adds some green Bollinger bands for color and context, along with a gray area graph of the SPX. Finally, I have included a purple line for the VIX:VXV ratio that reflects a 500-day exponential moving average (EMA) in order to show the long-term average of the ratio.

While there are many interesting nuggets buried in this chart, first note that the long-term average of the VIX:VXV ratio is not 1.00, but generally hovers in the 0.90 – 0.95. This reflects the fact that the VIX futures term structure has historically been in contango (upward sloping, with nearer months less expensive than more distant months) 75-80% of the time. Second, note that spikes in the ratio tend to coincide with bottoms in stocks and vice versa. Finally, note that even with the crazy VIX spike last August and September (and record backwardation, i.e. high VIX:VXV ratios), the ratio has been depressed since December and the 500-day EMA is now making all-time lows.

What does this mean? Lots of things, but in simple terms investors continue to believe that the VIX is unnaturally low given the scope and magnitude of the future threats to equities. Should the ratio continue at its current 0.83, I would be very concerned about the possibility of a bearish reversal.

[In order to keep this post to a manageable length, I have skipped over a bunch of related issues, but readers should feel free to wander down some of the same rabbit holes I have preserved in the links below.]

Related posts:

• VXV Heralding a Return to Normalcy
• Chart of the Week: VXV at Critical Juncture
• Take a Longer View on Volatility (Barron’s)
• Chart of the Week: VXV and Systemic Failure
• The VXV and Extreme Structural Volatility Risk
• VXV Is One Year Old
• The VIX, VXV and Volatility Expectations
• How to Create Your Own Portable VXV
• Thinking About VXV
• VIX Sets Two New Records
• A Conceptual Framework for Volatility Events
• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting
• The VIX, VXV and Volatility Expectations
• The VIX:VXV Ratio
• Chart Porn
• Unusual Chart of the Month: VXO and RVX
• The 1000^th Post

[source(s): StockCharts.com]

Disclosure(s): long VIX at time of writing

VXV Heralding a Return to Normalcy

With the political season heating up, it seemed like an opportune time to work “normalcy” into one of my posts again and what better way to do that than by putting under the microscope one of my favorite overlooked indices: the CBOE S&P 500 3-Month Volatility Index, which I typically reference with the more pithy VXV ticker symbol.

For those not familiar with VXV, I am fairly sure I was the first person to discuss this index back in 2007, talk about the merits of the VIX:VXV ratio (which is a great way for someone without VIX futures quotes to keep on top of the VIX futures term structure), devote an entire Barron’s column to the subject (Take a Longer View on Volatility) and promote VXV as a better reflection of long-term and structural/systemic volatility than the VIX, which is better suited to measuring short-term event volatility.

For those who desire some additional background and context, there are shiploads of prior posts on the subject and the links below should provide for some excellent jumping off points.

Getting back to VXV, I think it is important to note that while the VIX remains above its December lows, VXV has now moved below those lows and it plumbing levels that have not been seen since early August – and as VXV is a better gauge of structural and systemic risk than the VIX (not to mention largely untouched by the holiday effect), I think this is an important development to watch.

Frankly, the VXV chart looks a lot like it did back in early April 2009, when I penned Chart of the Week: VXV and Systemic Failure.  At that time I concluded, “The key takeaway: systemic healing is continuing and the risk of systemic failure is diminishing.” Based on the VXV chart, it appears as if we are at a similar moment in time right now.

Related posts:

• Chart of the Week: VXV at Critical Juncture
• Take a Longer View on Volatility (Barron’s)
• Chart of the Week: VXV and Systemic Failure
• The VXV and Extreme Structural Volatility Risk
• The VIX, VXV and Volatility Expectations
• How to Create Your Own Portable VXV
• Thinking About VXV
• A Conceptual Framework for Volatility Events
• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting
• The VIX, VXV and Volatility Expectations
• The VIX:VXV Ratio
• Normalcy Again? VWSI at –4
  
  

[source(s): StockCharts.com]

Disclosure(s): The CBOE is an advertiser on VIX and More

VIX Sets Two New Records

It is not every day that the VIX establishes some sort of new all-time record and it is rarer still that the volatility index sets two different records on consecutive days, but such has been the case at the beginning of this week.

The first record, established on Monday, was in the VIX:VXV ratio – a subject that I covered on a regular basis in the first year or so following the launch of VXV, which is essentially a 93 day version of the VIX and whose formal name is the CBOE S&P 500 3-Month Volatility Index.

Long-time readers will recall that for the first year after VXV was launched, the VIX:VXV ratio performed flawlessly (see VXV Is One Year Old.) In a post-Lehman world, however, the VIX:VXV ratio has been inconsistent as the persistent extreme contango has made the ratio more difficult to calibrate. I have been doing some work on this, however, and will share some of my thinking about how to tweak this ratio going forward.

The latest record, established today, is in my proprietary VIX Futures Contango Index. I spelled out some of my thinking about the epic disconnect between the cash/spot VIX and the VIX futures in a post a month ago with the title of VIX Futures: What Are/Were They Thinking?

In the end, the VIX:VXV ratio and the VIX Futures Contango Index both measure different aspects of the same phenomenon: how much current volatility readings vary from future market volatility estimates. I do believe that when estimates of near-term and long-term volatility show a record degree of divergence, some considerable opportunities are presented. As I have spelled out in a number of instances lately, my thinking has been that the back month volatility will likely collapse in order to bring the present and the future back into line. There has been some evidence of that happening during the past two days, but I anticipate that long-term volatility expectations will continue to decline.

On a related note, VXX has made a new all-time low six days in a row and counting...

Related posts:

• VIX and Historical Volatility Settling Back into Normal Range
• Will Market Volatility Return to Crisis Levels? (Barron’s)
• VIX Futures: What Were/Are They Thinking?
• VIX Futures Contango Soars
• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting
• The VIX, VXV and Volatility Expectations
• The VIX:VXV Ratio
• Thinking About VXV
• Take a Longer View on Volatility (Barron’s)

[source: StockCharts.com]

Disclosure(s): neutral position in VIX via options at time of writing

VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis

At the risk of beating to death last week’s theme of availability bias and disaster imprinting as part of the explanation for some of the “realized volatility gap, persistent VIX futures contango and off-center VIX:VXV ratio,” I thought it might be informative to present a simple piece of research which supports the idea that the 2009 volatility picture has been an extremely abnormal one.

In the 20 years of VIX historical data, the VIX has typically overestimated the realized volatility 21 trading days hence, which is reflected in the chart below by the dotted green RV (+21d) line. In fact, the gray area portion of the graphic, which represents the difference between the VIX and realized volatility 21 trading days later, was close to 30% in the first half of the 1990s; more recently it has been averaging closer to 20%. The VIX actually fell below realized volatility for 2008, which is not surprising, given the volatility extremes of October and November. What is particularly noteworthy about this chart, however, is that during 2009 the VIX is actually 3.8% higher than it was in 2008, which realized volatility has actually fallen 24.7%. It is almost as if the VIX refuses to believe that realized volatility is declining and insists that the gravitational forces of mean reversion be suspended until further notice. This is a large part of the reason why 2009 has been a boon to options sellers.

For additional posts in this series, which I have listed in reverse chronological order, readers are encouraged to check out:

• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting
• Availability Bias and Disaster Imprinting
• The VIX Spike Conundrum
• Anchoring and VIX of 20
• The Gap Between the VIX and Realized Volatility

The VIX:VXV Ratio, Availability Bias and Disaster Imprinting

Once a popular subject in this space, the VIX:VXV ratio appeared to be a casualty of the financial turmoil and record volatility spikes in October 2008, when the ratio spiked to record levels an generated a buy signal that turned out to be nothing short of a disaster.

I was not yet ready to give up on the VIX:VXV ratio, so I was pleased to see that from November to January it generated some helpful long and short signals. In a promising development, on March 2^nd the ratio generated a buy signal just before the markets bottomed. When the VIX:VXV ratio urged caution in June, I had even more reason to be hopeful. Then, once again, the ratio had another big miss, issuing a sell signal in mid-July just after the markets started rallying. To compound matters, instead of moving back toward the neutral zone (between 0.92 and 1.08), the ratio persisted with a bearish recommendation all the way to the October top.

I was just about to consign the VIX:VXV ratio to the “Sometimes Useful But Not Always Consistent” bin, but decided to reconsider when I started thinking about volatility levels in the context of availability bias and disaster imprinting, as well as The Gap Between the VIX and Realized Volatility and VIX Spike and VIX Futures Contango Means… As I see it, all these subjects are related. The realized volatility gap, persistent VIX futures contango and off-center VIX:VXV ratio (see chart below) are all symptoms of a market that is not functioning as it normally does, while availability bias and disaster imprinting are the main causes of this situation.

Further, the fact that the VIX futures term structure is now flat and the VIX:VXV ratio hit a new post-March 6^th high of 1.056 last Friday suggests that the volatility picture may be starting to assume some of its pre-Lehman characteristics – if not exactly returning to a ‘normal’ state of affairs.

Personally, I still think the VIX is a little higher now than realized volatility will be a month from now, but a high VIX relative to realized volatility may turn out to be one of the more persistent effects of the global financial crisis, as each investor has their own personal half-life for how long availability bias and disaster imprinting will cast a shadow on their view of the investment landscape.

For additional posts on some of the above subjects, readers are encouraged to check out:

• Availability Bias and Disaster Imprinting
• The VIX Spike Conundrum
• Anchoring and VIX of 20
• The Gap Between the VIX and Realized Volatility

[source: StockCharts]

Disclosure: Short VIX at time of writing.

Availability Bias and Disaster Imprinting

After I dashed off The VIX Spike Conundrum, it occurred to me that there might be some aspects of behavioral finance that have contributed to what is now a full year of continued overestimating of future volatility. I detailed this phenomenon in The Gap Between the VIX and Realized Volatility and is also being reflected in up in a VIX:VXV ratio that has been stuck at unusually low levels from mid-July until last week.

In thinking about the various elements of behavioral finance that impair ‘rational’ decision-making and could contribute to excess implied volatility, one factor that immediately comes to mind is availability bias (nicely summarized in Wikipedia.) The global financial crisis and VIX spikes into the 80s were so vivid and memorable – and so thoroughly discussed in the media – that they are all too easy to recall one year later, even though arguably most of the risks associated with a VIX of 80 have since passed.

I do not think that availability bias is the only explanation for recent excess implied volatility. My working hypothesis – which I do not believe has been addressed by the behavioral finance crowd – is that another factor is as work. I call it “disaster imprinting” for lack of a better name. Disaster imprinting refers to a phenomenon in which the threats of financial and psychological disaster were so severe that they continue to leave a permanent or semi-permanent scar in one’s psyche. Another way to describe disaster imprinting might be to liken it to a low level financial post-traumatic stress disorder.

I will do some additional research to test the disaster imprinting theory, but for now I wanted to throw the idea out and see what others think. Has going to the brink of a global financial meltdown impaired our collective ability to assess future probabilities? If so, how long will this impairment last? As always, all comments are appreciated.

For additional posts on related subjects, readers are encouraged to check out:

• The VIX Spike Conundrum
• Anchoring and a VIX of 20
• The Gap Between the VIX and Realized Volatility

Disclosure: Short VIX at time of writing.

Is VIX Being Artificially Depressed by Increased Use of SPXU?

The continued drop in the VIX below the 25.00 level caught a number of traders by surprise, including this writer.

If one were to study last Friday’s Forces Acting on the VIX, it would not take long to determine that with very few exceptions, the fear and uncertainty associated with the forces in the graphic have been rapidly diminishing over the course of the past few months.

One of the forces that I mentioned has received very little attention and has likely been underestimated by traders – if accounted for at all. This is the growth of hedging substitutes for the SPX. As the VIX is strongly influenced by the demand for SPX puts, it stands to reason that any substitutes for SPX puts could ‘artificially’ lower VIX levels by diverting demand to alternative hedging products. Historically, these substitutes have included futures, options and various forms of swaps. With the increased interest in ETFs and particularly leveraged ETFs, however, the menu of substitutes has increased dramatically.

During the height of the financial crisis, I documented how many investors were foregoing SPX and SPY puts in favor of options targeted specifically on the financial sector.

With the introduction of the bearish -3x Short ProShares (SPXU), a triple ETF aimed at replicating -300% of the daily move in the SPX, I believe traders have found – and embraced – an alternative to SPX options that is starting to impact the VIX.

The graphic below shows how the recent increased volume in the SPXU just happens to coincide with the decoupling of the VIX and the VXN. The same factors are undoubtedly impacting volatility term structure as well and may explain some of the recent low readings in the VIX:VXV ratio.

I am leaving the title of the graphic as a rhetorical question for the moment, as one month of data will necessarily leave us far short of any sort of statistical proof. Do not be surprised, however, if SPXU and its +3x sibling UPRO continue to generate larger interest and volume, both as a hedging tool and as a speculative play. As leveraged ETFs based on the SPX increase their market share, interest in SPX puts – and absolute levels in the VIX– may see a significant decline.

For some related posts, see:

• The Rising Popularity of XLF Options
  
• Interest in VIX Waning?

[graphic: VIXandMore]

Some Thoughts on Current Volatility

Being a West Coast guy, I often find myself three hours behind the rest of the blogging world when I stumble out of bed. Once or twice a year, I manage to sleep through the open and generally spend the rest of the day playing catch-up, as has been the case today. Now that I am mostly coherent and have digested the bulk of the news and market movements for the first three hours of today’s session, let me offer some comments.

While stocks are enjoying an Intel (INTC) inside jump, the VIX is up a shade as I type this, seemingly intent on staying above the 25.00 level. On the other hand, three of other major market index volatility measures I follow (VXN, RVX and VXD) are all down in the 5-7% range for the day. The outlier among the secondary volatility indices is VXO, the volatility index for the S&P 100 index (OEX), which is only down about 2% on the day. (I am not sure exactly how to parse this information, but with the meat of second quarter earnings season just around the corner and options expiration only two days away, I would not be surprised to learn that portfolio managers are looking to lock in some profits and add some additional downside protection.)

In the last day or two, a number of other bloggers have commented up on the volatility premium issue. In VIX Predicting the Future…and It’s Cloudy, Jason Goepfert of Sentiment’s Edge has an excellent chart of the premium of the front-month VIX futures to the spot VIX index and points out that a high premium has lately been bearish for stocks. Adam Warner of Daily Options Report picks up the premium theme in While We Were Churning…… as does the Decline and Fall of Western Civilization blog in Volatility Curve Warning Again.

The premise is exactly the same reasoning as is behind the VIX:VXV ratio and the VXX:VXZ ratio: when short-term volatility measures become substantially out of line with longer-term volatility measures, the divergence is most likely to be resolved by the short-term measure ‘correcting’ in the direction of the longer-term measure. With the VIX:VXV ratio recently hovering around 0.85, this means a VIX spike is more likely to take the ratio back toward equilibrium than a substantial drop in the VXV index. By the same token, VXX and VXZ are more likely to converge as a result of a jump in VXX than a decline in VXZ. Of course, the numerator and denominator can always converge at the same rate, but that type of resolution seems to be relatively rare.

For those who may be interested, my various estimates of fair value for the VIX are largely in the range of about 28-29 at the moment, suggesting that short-term volatility is due for a bounce soon.

As a reminder, anyone wishing to speculate on the VIX using options and futures should note that VIX options expire next Wednesday (July 22), with the last day of trading on Tuesday.

VIX:VXV Ratio Sell/Short Signal

The VIX closed at 26.36 today, down 15.4% from Monday’s close of 31.17 to the lowest closing level since the 25.66 close on September 12, 2008 – the last trading day before the Lehman Brothers bankruptcy was announced.

According to the classic 10 day simple moving average measure, which has the VIX currently sitting 11.7% below that level, the VIX is now in an ‘oversold’ position according to the TradingMarkets 5% Rule as well as a more stringent 10% threshold used by other traders.

From a volatility term structure perspective, the VIX is also oversold. Notably, the VIX:VXV ratio, which compares 30-day volatility of SPX options to 93-day volatility (using the VXV index), closed today at 0.896 today. In the chart below, you can see that when this ratio closes at 0.92 or below, the bears tend to have an upper hand for at least several weeks. When the ratio drops below 0.90, as was the case today, the odds shift even more favorably in the direction of the bears.

In brief, the low current levels in the VIX:VXV ratio suggest that options traders are too bullish and complacent in their 30 day outlook (event volatility) relative to their 93 day outlook (structural volatility.) While these two volatility measures can be brought back into line by lowering estimates of long-term structural volatility, the path of least resistance is for short-term event volatility to rise. This means the odds favor that the VIX will move in the direction of the VXV, which closed at 29.41 today. Of course rising volatility tends to favor the bears at the expense of the bulls. Even with today’s exceptionally strong close, longs should consider taking profits and/or initiating short positions.

[source: StockCharts]

Disclosure: Long VIX at time of writing.

VXX:VXZ Ratio

Since its launch on January 30^th, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) has generated an enthusiastic following, with an average volume of 400,000 shares traded each day. The same claim cannot be made of VXX’s more problematic sibling, the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), where 100,000 share days are more the exception than the rule.

In spite of the lack of popularity, VXZ, which attempts to replicate the changes in VIX futures approximately five months out, should not be overlooked. In fact, comparisons between the movements of VXZ and VXX provide some interesting insights into the ebb and flow of volatility expectations.

Take the VXX:VXZ ratio, for instance. In some respects this indicator is similar to the VIX:VXV ratio I introduced back in 2007. There are some important differences between the two ratios, however, which are worth noting. First and foremost, you can trade both VXX and VXZ; neither VIX nor VXV can be traded directly. Second, and related, both VXX and VXZ are exchange-traded notes (ETNs), while VIX and VXV are indices. Finally, whereas VXX and VXZ look out one month and five months, the VIX and VXV indices look out one month and three months.

For those seeking to compare near-term volatility expectations with volatility expectations several months out, both the VIX:VXV ratio and the VXX:VXZ ratio are excellent tools. From a data perspective, the index ratio has 19 months of real-time historical data. Unfortunately, the VXX:VXZ ratio has only 4 ½ months of real-time (i.e., non-reconstructed) data to draw from. On the other hand, data for the VXV index is sometimes difficult to come by, while VXX and VXZ data are widely distributed.


The chart below shows the full history of the VXX:VXZ ratio, using a 4-day EMA (blue line) as a smoothing factor. While this indicator is still quite youthful, I find it encouraging that the recent bottom in the ratio coincided with a topping pattern in the SPX. Further, the double top in the ratio that completed on March 9^th also coincides with the bottom in the SPX.

Going forward, I will compare the VXX:VXZ ratio to the VIX:VXV ratio and subject both ratios to some additional scrutiny.

[source: StockCharts.com] 

Disclosure: Long VXX and neutral position in VIX via options at time of writing

VIX:VXV Ratio Slips Below 0.92 Intraday

Several factors have contributed to my taking a more bearish stance today, including a VIX:VXV ratio of 0.92, up from a low of 0.919 a little earlier.

Among the ways to get long volatility in this environment of rapidly falling volatility is VXX, the short-term VIX ETN, which looks like an attractive long at the current at 74.79.

VIX:VXV Ratio Moving Toward Bearish Zone

Lately I have received quite a few requests to talk about the VIX:VXV ratio, something that I first blogged about back in December 2007, shortly after the VXV volatility index was launched.

The chart below is my standard VIX:VXV ratio chart and uses the 1.08 and 0.92 end of day closing levels as basic long and short signals. The last signal on the chart is a March 1^st long signal that preceded the March bottom by a week. On April 19^th the VIX:VXV ratio closed at .9276, but was below the 0.92 signal line on an intraday basis.

Yesterday, I saw some data that showed the VIX:VXV ratio below 0.92 during the trading session, but a review of the intraday chart tells me that while the VIX:VXV ratio was in the 0.9150 to 0.9200 area from about 9:50 a.m. to 10:10 p.m. ET, any lower numbers were likely to have been the result of bad prints.

For the record, while yesterday’s 0.944 close suggests a bearish bias, my reading of the ratio is that the preferred entry point for shorts positions would require waiting for a close of 0.92 or below.

[Note that while this basic interpretation of the VIX:VXV ratio sets parameters for long and short entries, it does not include recommendations about exits or how to incorporate the VIX:VXV ratio into a trading system.]

[source: StockCharts]

Disclosure: Long VIX at time of writing.

VIX:VXV Ratio Down to 0.92

With the SPX at 873, it looks like a good time to get short to me...

Looks Like No EOD Buy Signal From VIX:VXV Ratio

At 3:45 p.m. ET the VIX:VXV ratio is at 1.051.

Now this ratio will continue to update until 4:15 p.m., but for those looking for a signal to get long during the regular trading session, it does not look like we will have one.

VIX:VXV Ratio Signals a Buy

The VIX:VXV ratio, which has been decidedly neutral for more than two months, is up over 1.08 (was at 1.10 earlier), signaling a buy.

Officially, this ratio does not generate a buy or sell signal until the end of the day, but on days like today, it is always nice to get an early warning signal.

If all hell does not break lose, I will revisit the VIX:VXV ratio just before the close and update the signal, if any.

Spot VIX vs. VIX Five Month Futures

Tuesday I went the analogy route in Thinking About the New VIX ETNs. Today I thought I should try the direct route and show a graph of the difference between the cash/spot VIX and the VIX futures five months out.

Keep in mind that the Barclays VIX ETNs, which are scheduled to begin trading tomorrow, target constant weighted average futures maturities of one month (VXX) and five months (VXY). The methodology used to achieve the constant maturity involves the blending of different proportions of various futures maturities each day. The chart below is slightly different in that it utilizes VIX futures with five months to maturity, but only rolls the contract out once per month. Nevertheless, it provides a very good approximation of the difference between the cash/spot VIX and the VIX futures with five months to maturity. Apart from confirming the large difference between current volatility expectations and expectations 5 month out, the peaks and particularly the valleys in the differential between the VIX and VIX five month futures show a high degree of correlation to the peaks and valleys in the SPX during the same period.

Something to think about, anyway, as the VIX ETNs near the starting gate.

And yes, these principles are similar to what I have talked about at some length with respect to the VIX:VXV ratio. For the record, the VIX:VXV ratio sits at 0.976 as I type this, slightly bearish, but consistent with the tight range this ratio has been in over the course of the past month.

[source: FutureSource.com]

For some additional perspective on the new VIX ETNs, check out:

• Should You Trade the VIX ETNs (Condor Options)
• VIX ETN Not a Wild Enough Ride (Jim Wiandt, IndexUniverse)
• Gimme Some ETNs (Daily Options Report)
• Barclays Readying ETNs Tied to VIX Futures (John Spence, MarketWatch)

…and for those who may have missed it, I published some initial thoughts on VIX ETNs from the top bloggers over the weekend in Barclays VIX ETNs Slated to Begin Trading on Friday.

What the VIX Thinks About Tuesday’s Breakdown

I know I shouldn’t be referring to the VIX as a sentient being, but I get so many questions along the lines of “what does the VIX think about…?” that I hope I can be excused for an occasional anthropomorphic slip of the keyboard.

In any event, I think the equity markets are at an important inflection point at the moment, with large commercial banks across the globe breaking down and starting to pull the major indices with them. Momentum is decidedly in the bearish camp and while today’s volume was of the fair to middling variety, we appear to be as close as one or two trading days away from the type of meltdown that could make November a fond memory.

Of course there are several possible scenarios and not all of them are bearish.

The chart below is one of my basic VIX charts and uses 10% and 20% moving average envelopes to bracket a 10 day simple moving average. The VIX closed 23.3% above the 10 day SMA, clearly at overbought levels, but as September and October showed, this is no guarantee we have hit a reversal point.

I also like to study the VIX relative to various historical volatility measures for the SPX. This too suggests an extremely extended VIX, with 10, 20 and 30 day historical volatility currently all residing in the 33-37 range.

The ever popular VIX:VXV ratio, which considers some elements that are analogous to the VIX term structure, is more neutral, with a slightly bullish reading of 1.032.

When I looked for historical data points that closely resemble the current situation I struggled to find analogous data. Only two periods come close to matching the present: October 2007, just when the markets were putting in a top; and July 1993, when the markets were slowly running out of steam, prior the bearish 1994 that preceded the great bullish leg from 1995-1999.

All things considered, my best guess is that the VIX is soon to begin suffering from oxygen deprivation and is not likely to climb much higher than the current altitude, providing some relief to the markets and keeping the SPX above the 770 level – perhaps even establishing 800 as the new SPX floor. The large pool of cash on the sidelines is sure to be tempted at current levels, but will not likely chase equities until there are some more convincing signs of a bottom forming. The next week or two could well determine whether the balance of the first half of 2009 is bullish or bearish.

[source: StockCharts]