New 2008 Low in the DJIA, Yet VIX Shows Complacency

I have received a number of questions and comments in which readers have expressed surprise about the relative complacency in the VIX (currently at 23.51 as I type this) while the DJIA is in the process of making a new low for the year.

One important and often overlooked element of a VIX spike is surprise. Similar to Nassim Taleb’s idea that a black swan cannot be anticipated, if all of the Bob Janjuah’s of the world predict an impending market crash, the media runs with the story, and investors rush out to snap up portfolio protection…then it becomes much less likely that people will panic and the market will crash if stocks start to turn down. Put another way, where there is a safety net, there is a lot less fear.

Another point worth noting is that the DJIA is not representative of the broader markets, as reiterated by Adam at Daily Options Report today in Lookout Below? The Russell 2000 and NASDAQ-100 indices, for instance, are showing considerably more resiliency in the recent downtrend.

Turning to the VIX:SDS ratio, which I unveiled last August in Fear vs. Volatility (follow the links for some background and explanatory notes), I use this indicator to evaluate the amount of fear and complacency in the market relative to market movements. The size and direction of the gap between the current ratio and the 100 day SMA or the 10 day SMA and the 100 day SMA provide some useful information about the incremental sentiment involved in market moves.

At the moment, it looks as if the VIX:SDS ratio is showing a small amount of complacency, which I find a little unusual for the current market environment, but not particularly noteworthy. Of course, if investors see the monster approaching and prepare themselves accordingly, it is a good bet that the monster will never quite make it close enough to terrify the markets.

Schaeffer on the Volatility of the VIX

Bernie Schaeffer is out with another interesting take on the VIX today. In Schaeffer’s Short Takes: The Volatility of the VIX (may require free registration), he offers some compelling data and charts on the historical volatility of the VIX.

The charts make for good reading, but it is Schaeffer’s conclusion that I wish to focus on:

“From a sentiment perspective, one might conclude that a high ‘second derivative VIX’ is an indication of excessive bearishness. At the very least one can reasonably conclude that if the protection trade is in fact crowded, then the chances of a major downside accident are significantly reduced as big money is already down on the black swan event.”

The important point is that the more downside protection that investors load up on (using VIX calls or by buying puts on other indices), the less impact any downturn will have. In other words, there will be little in the way of a vicious cycle of selling if options are mitigating losses from a bear move. By the same token, a black swan event, by definition, has to be a surprise. If investors are prepared for the beast, then it will have to arrive in another form, if it arrives at all.

As an aside, I don’t believe the term ‘second derivative VIX’ is the best phrase to use when speaking about the historical volatility of the VIX. The VIX is the implied volatility of the SPX, so a second derivative would logically refer to the implied volatility of the VIX, something I have labeled meta volatility in this space in the past. While technically one can derive both historical and implied volatility from the VIX, mixing historical volatility and implied volatility together in this context muddies the already murky waters of what a VIX derivative is.

It sounds like it is about time for another VIX 101 post to clarify some of this…

March Madness and the Sweet 64

It has been quite a week, especially for VIXophiles. Not only is March Madness just around the corner, but we had our own VIX bracket buster on Tuesday when the VIX posted a sweet 64% gain.

Highlights from the week include…

Jim Kingsland being the first I saw to report that the China selloff was engineered

Brett Steenbarger putting big down days in perspective and setting expectations going forward, then adding an interesting kicker

Ticker Sense on where in bull/bear market cycles 3% declines are most likely to occur

Tim Price with my favorite quote + article look back at the drop

Adam Warner on some of the problems with VIX options

David Merkel on the definition of liquidity (the post was from the previous week, but since I just discovered The Aleph Blog and added it to my blogroll this week, I am bending the rules a little here)

blackenterprise.com picks up a story on Hedge Fund Research adding a Volatility Index for “tracking the performance of hedge fund managers who trade volatility as an asset class.”

This week’s irony award goes to Tim (Don’t-call-me-Permabear) Knight, who was snowed in somewhere in bear country when the real thing was waltzing down Broad and Wall. Tim is always a good read but should be one of your first stops when things get bearish.

Finally, I usually do not make predictions, but it was a strange week, so I thought I’d share several additional items of a personal nature, perhaps all black swans:

• What is the likelihood that a guy who has a blog with the title “VIX and More” would have his birthday on the day the VIX has a historic spike?
  
  
• What is the likelihood that I would talk about earthquakes as a metaphor for volatility and then feel one just a couple of hours later?
  
  
• What is the likelihood that I would make my first specific prediction about volatility for the coming week just last week (I thought predicting a 17% increase was going out on a limb) and talk about the need for having a plan for a -300 Dow day?

More on the VIX Fizz on Fed Days

We have already established that the VIX tends to fizzle on Fed Days, but how often does it pop 10% following an announcement?

Not very often, it turns out. In fact, you have to go back 104 Fed meetings ago to February 4, 1994 (the same 1994 that Doug Kass was talking about as a 'bear template') to find the most recent 10% Fed Day VIX spike upward -- and that is the only 10% Fed Day jump since the VIX was officially rolled out in 1993.

It should come as no surprise that 1 in 104 is almost in the black swan category in terms of the VIX. I noted previously that almost 1 in 3 weeks sees a VIX move of 10% in one direction or the other, so don't expect to be surprised on Wednesday and think long and hard about paying a premium to get a front row seat to see the next black swan.