Wednesday, January 31, 2007

A Month By Month Look at the VIX

I’ll cut to the chase and put the graph of the monthly closes (with all values normalized to a monthly mean of 100) in the VIX first:

Since the picture tells almost the whole story, I’ll add only a few supplemental comments:

  • We are currently in the middle of the November-March doldrums
  • March-June and June-September are the two monthly volatility trends to keep an eye on
  • From a “sell in May and go away” perspective, the May-August period has included the VIX high month only twice, but the low VIX month ten out of seventeen years

Tuesday, January 30, 2007

What My Dog Can Tell Us About Volatility

I am fortunate that my dog, Logan, is a well-adjusted, happy-go-lucky, 1 ½-year-old canine. To put things in perspective, his idea of a bad day in the market is any time we come home from the grocery store without cheese.

It turns out, however, that he is a walking (or running) volatility laboratory. A typical example of this is the occasional distant noise that just barely penetrates his perceptual radar, particularly on those quiet evenings when he is napping contentedly with the family. Upon hearing the noise, Logan’s altertness instantly spikes, he lets out an involuntary woof, then carefully tunes his ears to their most sensitive setting, seeking any information that will help identify the source of the noise. Usually there are no other disturbances to follow and the noise is catalogued and soon forgotten. His alertness level slowly subsides over the next 10-15 minutes or so and he goes back to napping, a little more fitfully this time and just a little bit on edge.

Things get a little more interesting when another noise surfaces shortly after the first one. What could once be dismissed as the wind, the house settling or some such insignificant event now must be treated as a threat – and just to be safe, a threat of the highest order. Now the appropriate response is a series of barks, nervous glances in the direction of the other members of the pack, brief pacing around, and a rushing off in the direction of the noise to investigate, with a flurry of barks meant to sound more menacing than the source of the noise. Who or what is it? How much harm can they cause? How grave is the threat?

It is the second noise – and any subsequent noises – that creates the equivalent of the Homeland Security red alert and triggers a response similar to what I call “echo volatility” in the markets. Once the elevated level of alertness has been established, it takes a long period of relative serenity for it to subside. On the other hand, when on red alert, any additional noises – big or small – will be magnified and regarded with the utmost caution.

In some respects, my dog is a lot like your typical investor and once he hears two or three threatening noises in a short time frame, it is a good bet that the second leg of a volatility spike is just around the corner.

Monday, January 29, 2007

Raymond James: QID or VIX for a Downturn?

Tucked at the very bottom of a article by Jeff Saut, Chief Investment Strategist of Raymond James, comes this gem:
" firm prefers the idea of buying “call options” on the Volatility Index (VIX) as an alternative to buying the QIDs, despite the fact that “longing” the VIX has proved to be a losing strategy over the past few months."

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.

Sunday, January 28, 2007

VIX Price Movement Around FOMC Meetings

In VIX Performance During the Options Expirations Cycle, we fired a shot across the bow of the options expiration volatility myth. Now we turn our attention to volatility associated with FOMC meetings.

I looked at end of day price changes in the VIX covering a period of 10 days prior to the FOMC announcement to 10 days following the announcement, from 1990 to the present . I normalized the EOD VIX on announcement day at 100 to make for a more meaningful scale and the following picture jumped out at me:

The graphic tells the story rather succinctly and it suggests that it is wise to be short volatility on the day before the FOMC announce and to be long volatility the day after the announcement, with the expectation of a volatility mini-crush of sorts, on the order of about 3.5% -- with half of that move coming on announcement day and the other half of the move coming the day after the announcement.

It turns out that Peter Carr and Liuren Wu published some similar observations in May 2004, so I checked to see if the publication of that information resulted in a change in the trend. To my surprise, the trend has remained relatively intact in the subsequent 21 data points over the past 2 ½ years:

Looking at the more recent data, the mini-crush has been closer to 3.0% since May 2004, but two key differences should be noted:

  1. Over 90% of the mini-crush has happened on announcement day, with very little movement on the subsequent day

  2. Volatility has no longer reverted to pre-announcement levels in the week or two following the announcement, rather it has remained lower post-announcement in the past 2 ½ years

Of course, there is considerable risk in jumping to conclusions that the 21 most recent data points are defining a new context for FOMC announcement volatility, but that possibility bears watching.

Saturday, January 27, 2007

Absolute vs. Relative Highs and Lows in the VIX

Price Headley, founder of, is one of many who maintain that the best way to think about the VIX is not in terms of absolute numbers and a multi-year lookback period. He recommends that traders focus instead on relative highs and lows over the course of recent trading ranges. Specifically, Headley favors 20-bar Bollinger bands with 2 standard deviations and opines,

"...forget about where the VIX has been in years past, and instead focus on getting the most of out the VIX using relative bands like Bollinger Bands. You can see that when the market tagged these lower boundaries for the VIX, as in mid-December and mid-November, then the market is ready to correct or at least go sideways. This follow-up information will prove invaluable as a contrarian, being willing to sell the market when the VIX is at its lower band, while being able to get more aggressive when we see fear spikes to the upper band. "
For the record, I am a strong believer in applying Bollinger Bands to the VIX and am of the opinion that Bollinger bands can provide solid trading setups not just for the broader markets, but for the VIX as well.

Friday, January 26, 2007

What to Expect from a VIX Spike

Some things to think about while considering how far and how fast the current VIX spike move will go:

  1. Most VIX moves up are of one of three durations: 1 day; 3-5 days; or 2-4 weeks. A VIX spike up for 3-4 days is fairly common, but there is no reason to expect it to end there.

  2. The magnitude of most sharp VIX spikes is at least 20-30% -- and yesterday was only 13%, so don't expect we are done from that perspective either.

  3. As to my target VIX highs in the short to intermediate term, I expect we will go at least to the 39 week SMA of 12.85, more likely to the 14-15 range. That being said, I would not at all be surprised to see something along the lines of the meltdown of May-July 2006, where the VIX traded north of 20.
A look at the weekly chart of the VIX should give you a visceral sense of how sharp of a move is possible.

Thursday, January 25, 2007

1994 All Over Again?

Apropos of the recent discussion about previous periods of low volatility, Doug Kass at TSCM has an article, Bears Locate a Template for a Crash, devoted to the many similarities between early 2007 and early 1994.

Kass succinctly recalls what happened in 1994:

"A two-month drop of nearly 10% in the S&P 500 Index began at the end of January 1994. The emerging markets collapsed -- Hong Kong's market fell by a third and Mexico by an even greater amount. The bond market got schmeissed -- by year-end, the 10-year U.S. note had fallen 20 points, correcting the entire gain of the previous three years. Finally, the VIX fell back to 1990 levels, climbing from 9 to 24 in only two months..."
Today's 13% rise in the VIX does not necessarily herald the beginning of another sharp shock, but it should be enough to make the bulls a little more skittish for awhile.

Two Ways to Play the Sub-10 VIX

No one has complained (yet), but I think it's time for some more brevity in my posts.

Here is what I am thinking: I suspect that one of those 20+% VIX moves may be right around the corner, but I wouldn't be surprised if we are entering a longer volatility lull than we have in the recent past, such as was suggested by the Faux-VIX.

This means that one way to play VIX 9.89 is to buy the calls outright; my preference is to put on a call backspread, which I can do for a credit. I'm looking at selling 1 of the Feb 9 calls (2.25-2.45) for every two of the Feb 11 calls (0.85-0.90) I buy. Another possibility is to do the trade with calls that are entirely out of the money: sell 1 Feb 10 (1.40-1.45) for every 2 Feb 12.5s I buy (0.45-0.55).

Since I already own some of the Feb 11s outright, I can leg into the Feb 9/11 position, then watch to see if either of these two setups can be established for a larger credit during the day today. At current market prices, a new position would be profitable below 9.45 and above 12.55, with a maximum loss at 11.00. Of course, profitability above 12.55 is theoretically unlimited. I will watch to see if these numbers get better during the course of the day.

Just prior to opening, the SPX futures are down a little, while EBAY and QCOM have the Nasdaq poised to open higher.

Wednesday, January 24, 2007

A History of Sub-10 VIX Closes

Today the CBOE Volatility Index closed under 10.00 for just the ninth time since it was launched in 1993. Three questions immediately arise from this fact:

  1. What is the history of sub-10 closes?
  2. What does the current one mean?
  3. How might the current situation be tradeable?

Today we will start with the first question, touch on the second one, and push the third one off until tomorrow morning.

The 1993-94 Lows

Looking at the history books, prior to 2006, the VIX closed below 10.00 on five occasions: four consecutive days in late December 1993; and once in late January 1994. In all instances, the VIX rebounded sharply higher 3, 5, 10, 20 and 50 days later. For the record, the SPX was little changed in the 3/5/10/20/50 day time from the four consecutive days in December 1993, but did sell off following the January 1994 low.

The details are as follows:

Sub-10 VIX #1-4) On 12/23-24/1993 and 12/27-28/1993 the VIX closed at 9.31, 9.48, 9.70 and 9.82, respectively. For comparison purposes, the SPX closed in the range of 467-471 during the same period. Three days later, the VIX was already up 6%, 10%, 10% and 19%. By the fifth trading day, those same gains had been extended to 15%, 23%, 30% and 21% from those closes. Ten trading days from the VIX lows, the VIX was up 21%,16%, 11% and 15%, while the SPX was anywhere between flat to up 1.0%. Twenty trading days from the lows, the VIX still showed cumulative gains of 20%, 17%, 20% and 16% from the original lows, with the SPX flat to up 1.6%. The more dramatic action came in the next 30 trading days, as 50 days from the original lows, the VIX was trading between 14.41 and 16.23, for cumulative gains of 72%, 50%, 57% and 47%. By the 50 day mark, the SPX had drifted down slightly, between -0.6% and -1.0% of the corresponding December close. The bottom line: the VIX was a good long at these lows and the SPX did not move for the next 50 trading days. In fact, there was no substantial drop (single day or cumulative) in the SPX until February 1994 and the SPX drifted sideways until the end of March 1994.

Sub-10 VIX #5) About a month later, on 1/28/1994, the VIX closed at 9.94, the last time it would close that low until November 2006. Looking at the same 3/5/10/20/50 day trading frame, the VIX rallied from that low to 10.61, 15.25, 14.46, 14.87 and 16.62, representing gains of 7%, 53%, 45%, 50% and 67% from the low. This time there was movement in the SPX, as it posted moves of +0.7%, -2.3%, -1.8%, -2.4% and -6.5% over the corresponding 3, 5, 10, 20 and 50 trading day periods. The big move behind the SPX numbers was a -2.3% drop in the SPX on the 5th trading day following the 1/28 low. This also happens to be the 28th, 29th, 30th and 31st trading day following the four consecutive December 1993 VIX lows. For the next 65 trading days, the SPX slid steadily lower, from 469 to 460, before dropping another 21 points over the course of four trading days.

A New Era in 2006-07?

Sub-10 VIX #6-7) On 11/20-21/2006, the VIX closed below 10.00 for the first time in a dozen years. While the 50 day ROI calculations are still two weeks away, the 3/5/10/20 day analysis shows gains of 8%, 17%, 13% and 3% for the first date and 24%, 9%, 14% and 4% for the second date. These VIX lows occurred in the fourth month of what is now a continuing six month upward move in the SPX, which has it currently 2.7% and 2.8% above the corresponding November values. There was a -1.4% drop in the SPX three trading days after one close and four trading days after the other close, on 11/27/06. I would not consider this drop to be noteworthy, however, as it was fully retraced over the course of the next two trading days and indeed the SPX has moved decisively higher over the past two months.

Sub-10 VIX #8) On 12/14/2006, the VIX once again closed below the psychologically significant 10.00 barrier. In the subsequent 3/5/10/20 day period, the VIX has had relatively tepid gains of 3%, 6%, 16% and 6%. The SPX has been drifting sideways for most of this period, but with today’s strong move now stands 1.0% above the 12/14 close.

Interpretation of the Current (#9) Sub-10 Close

To say that the VIX has closed under the 10.00 mark nine times is to stretch the truth a bit, as some of these daily closes might better be considered as multiple instances of two short-term volatility lulls in late 1993 to early 1994 and late 2006 to early 2007. Each of these two periods had a multiple days of consecutive sub-10 closes followed by an “echo low” approximately one month later. So far, today’s sub-10 close can only be considered another echo low, until we see how the balance of the current VIX lull plays out.

This categorization has important statistical implications. Is it two clusters of lows or nine independent data points? Either way, the small sample size has little statistical validity, but it is harder still to draw conclusions from two data points scattered over the course of 15 years.

Still, the data reflect that for each of the previous sub-10 closes, the VIX was higher 3, 5, 10, 20 and 50 days after the sub-10 close. For the 20 day period, the VIX has always rallied at least 10% and an average of 19% from the low. For the 10 day period, the returns are more widely dispersed, but the average is 22%. If we look out 50 days, the minimum return is 47% and the average return is 60%. The important caveat is that the 50 day ROI data do not yet include reaction to the 2006-07 VIX lows.

Now that investors have become somewhat accustomed to the low VIX numbers, we’ve been hearing the “It’s different this time!” calls for the past few months – and perhaps it is. Today is the 22nd day in a row that the VIX has set a new low for the 100 day SMA. I’m not convinced that it is different this time, but I do think that any knee-jerk reaction to buying VIX calls is not the best way to approach the current situation.

Scholarly Thoughts on VIX, Volatility and Everything Else

Tired of being shut out of the latest thinking on implied volatility at Goldman, Credit Suisse or BGI? Think your interests are too narrow and arcane for normal web searches because the type of information you’re looking for is relegated to obscure monthly and quarterly journals? I think I may have a solution, albeit an imperfect one.

Thanks to the omniscient folks at Google, you can cherry pick pearls of wisdom from the leading academic journals across the globe without even having to leave your browser. Google Scholar, which bears the motto, “Stand on the shoulders of giants,” is not to be taken lightly. I asked for articles on VIX and volatility from just the past year and got 53 hits; searching the entire database yielded 693 articles.

A glance at some of the hits reveals articles from the following sources:

  • Journal of Futures Markets
  • Journal of Portfolio Management
  • Journal of Business & Economic Statistics
  • Journal of Finance
  • Journal of Econometrics
  • Journal of Financial and Quantitative Analysis
  • Journal of Economic Literature
  • Journal of Financial Research
  • The Journal of Business
  • American Economic Review
  • National Bureau of Economic Research
Some of the more intriguing titles from the past year or so that I browsed include:

Granted, some of these articles require a small fee to be downloaded, but all the titles mentioned above are free. So check out Google Scholar and see what academics are thinking about your favorite arcane guilty pleasures.

Tuesday, January 23, 2007

A Challenge to Two Things You Think You Know About the VIX

From Jason Goepfert via the virtual pen of Steve Sjuggerud and archives of Investment U and comes several VIX-related ideas that are worth mulling over 1 ½ years after they were published.

Goepfert, who heads up Sundial Capital Research and, attempted to reconstruct what historical VIX data might have looked like if it were possible to simulate VIX readings all the way back to 1900. In this manner he developed what he calls a Faux-VIX that looks back over a century. As described by Sjuggerud, Goepfert determined that while current VIX readings look quite low by the historical standards that cover two decades of official CBOE VIX/VXO data, looking back to 1900 with the Faux-VIX, it appears that volatility readings below the current 11 level happen approximately one third of the time.

Further, and consistent with the initial post in this blog, Goepfert concluded that sustained periods of high volatility tend to alternate with lengthy periods of low volatility in cycles which average approximately five years. Much to my surprise, Goepfert then concludes that “buying the first large spike in volatility has paid off time and time again.” This contrasts sharply with my current thinking, which favors capitalizing on the mean-reverting tendencies of the VIX by fading large volatility spikes.

In future commentary, I will examine the degree and duration of various types of volatility spikes and return to Goepfert and the fade-or-buy-the-spike debate.

Note: For those who may be interested, Goepfert is a frequent contributor to and archives of his articles on that site can be found here.

Monday, January 22, 2007

On the Nature of Fear

Fear is a strange animal. It is easy to unleash, yet hard to put back in a cage. It spikes up, but rather than spiking down, it tends to slowly subside over time.

Why is this the case?

In the stock market, there are many factors that may spook investors. In the future I am considering trying to construct a formal Taxonomy of Fear, but for now, let me offer some examples. In the global political arena there are fears that range from terrorism, nuclear proliferation, Middle East tension, and a war in Iraq that could spiral out of control, to the spread of socialism in South America, China playing hardball with the renminbi, Russia throwing their weight around with energy and natural resources, etc. On the macroenomic front, is it inflation or deflation we should be more concerned about? Throw in the possibility of a recession, productivity declines and a hiccough in the job creation engine and there is the potential for a stagflation stew. Really want to make it nasty? Add a dollop of bird flu or SARS on the health front, sprinkle in some peak oil talk and the possibility of another large hedge fund or two imploding and you can see how emotionally charged the investment horizon can appear.

These are not one day events, either. These are the types of issues that grab headlines day after day after day. Whether or not the reality of the situation is worsening, play in the media will manage to keep these issues in the headlines and top of mind for the investment community – and with it, a sense of fear.

Very few of these fears can be defused overnight. The geopolitical issues, in particular, tend to persist for decades, with relative visibility ebbing and flowing over time. For the most part, economic fears and health fears are not going to be quelled in the short-term either. At best, they may come and go in cycles and even if they do fall off of our radar, new concerns are likely to bubble up to take their place.

Ultimately, fear spikes, often instantaneously, and leaves an emotional imprint. If too many unsettling events -- or even one event of seismic proportions -- result in the piercing of the comfort threshold of the average investor, then echoes start to show on the tape and fear cannot be put back in the cage.

The data make this clear. The VIX, which in some respects resembles fear, is seven times more likely to spike up three standard deviations in one day than to spike down; it is fifty times more likely to trade three standard deviations above its 10 day moving average than below it. Asymmetrical VIX spikes are not just an issue of frequency, but one of degree too. On the 26 days that the S&P500 has fallen by 3% or more in a single day, the VIX has spiked up an average of 16.8%. Conversely, on the 33 days in which the S&P has risen 3% or more, the VIX has fallen only 9.2% on average.

In most instances, an investor would have been well served to bet on these VIX spikes reverting to the mean within a week or so, but a better understanding of the taxonomy of fear and of important fear thresholds is critical to assessing when to fade the trend and when to ride it.

Friday, January 19, 2007

Volatility: Options Expiration Cycle vs. Earnings Season

For those who wonder why VIX options prices sometimes seem to bear little resemblance to movements in the VIX, Brian Overby at TradeKing has a good article, Decoding the VIX II, that explains how VIX options prices are a function of VIX futures prices, not the underlying VIX prices. (FYI, you can find the first half of Decoding the VIX here.)

Overby discusses some of the implications of this pricing phenomenon and concludes:
"This means that the relationship between the actual VIX index and the VIX options “based” on that index are little hard to follow."
While am quick to nod my head in agreement at this, his metaphor about predicting the weather four months in advance based on current data hits closer to home.
"In simple terms, trading VIX options is like trying to trade options on the temperature at some future date. If, for some odd reason, the temperature in south Florida reaches 120 degrees on October 5, that does not help someone to predict the temperature on February 5 of next year. Perhaps, if there a string of 120-degree days, then, maybe, there could be a trend that might presage a warmer winter and a higher than normal temperature on February. Under normal conditions, however, what happens to the temperature on one particular day in September bears very little relationship to what weather will be in February."
More on what this means to come, but the thoughts here might help those trying to understand some of the many idiosyncracies of the elusive VIX.

On another front, Clare White at recently authored CSCO IV Seasonality, which discusses the seasonal implied volatility cycles associated with CSCO and earnings releases. Not surprisingly, graphs of CSCO IV show that IV ramps up in the weeks leading up to earnings and spikes for several days before before earnings, only to subside dramatically after the announcement.
CSCO 2006 implied volatility

The implications, of course, are much broader than CSCO and include the VIX. Since the VIX is looking ahead to volatility over the next 30 days, it is important to know when the S&P500 heavyweights are scheduled to report.

For 2007, I have looked at the reporting dates, by week, for the S&P500 and come up with the following table to identify the number of companies that report each week and in each four week cycle:

Week Current Week Current + 3 Weeks
Week 1 2007 2 166
Week 2 2007 (-1) 4 262
Week 3 2007 (opt exp) 45 307
Week 4 2007 (+1) 115 282
Week 5 2007 98 202
Week 6 2007 49 104
Week 7 2007 20 55

Note that the week after options expirations week is at the peak of the earnings reporting season, with the most companies reporting (115), while the weeks before, during and after options expiration have a roughly equivalent number of companies in the SPX reporting during the four week window that roughly coincides with the VIX futures calculation horizon.

With these two thoughts reverberating in my head, I went back to the VIX Performance During the Options Expiration Cycle post, separated out the prime earnings reporting months (January, April, July and October) and compared them with the other eight non-earnings months. I did this for the week after expiration, which happened to show the highest volatility in my previous analysis. Sure enough, the earnings months were 50% more likely than non-earnings months to show VIX moves to the upside of 10% or 15% and more than twice as likely to show moves of 20% or more.

While the data still support the week after options expiration as the biggest volatility week, it turns out that in non-earnings months, the week after options expiration is no more volatile than average. The bottom line is that, as far as I can tell, it is the proximity to earnings releases that makes the week after options expiration more volatile than other weeks. Perhaps more importantly, in terms of the influence on volatility, earnings season trumps the options expiration cycle by a large margin.

Wednesday, January 17, 2007

Meta Volatility (...or IV^2?)

So...the VIX is a measure of implied volatility and the VIX has options. Those options also have implied volatility. So...what the heck is the implied volatility of implied volatility and what does it mean?

First, the easy part.

Photobucket - Video and Image Hosting

So, there you have it. A year of implied volatility of implied volatility.

Some quick observations on what it might mean before I take a sharper analytical knife to the data:
1. High correlation between VIX price and 30 day historical volatility (no surprise)
2. A couple of interesting large IV spikes in the past month that are atypical
3. Recent divergence between IV and VIX price trend is unusual
4. VIX IV appears to have averaged around 100 in the past year
5. IV downward spikes in the 60-70 range were short-lived and appear to have provided a couple of good buy signals
6. VIX IV is not the rate of change of the VIX -- and the lack of correlation to same is striking, at least to me

Tuesday, January 16, 2007

VIX Performance During the Options Expiration Cycle

How does the VIX generally perform during options expiration week? What about the week before options expiration week? The week after?

After crunching the weekly closing data, here are some summary comments about each of these three weeks:

Options expiration week
This week is the only week where the VIX has traditionally made a significant move down, probably a case of reality falling short of the expectations that some associate with -- and plan for -- on triple and quadruple witching expiration weeks. On average, options expiration week has the VIX falling 2.7%, compared with an average rise of 1.4% on non-expiration weeks. The VIX is significantly more likely to fall 15% or more on this week than on any other week. Correspondingly, this is the week in which the VIX is least likely -- at least in terms of historical data -- to spike to the upside.

The week before options expiration

As many times as I have seen things heat up the week before options expiration, it came as a surprise to me to see that the week before options expiration consistently displays lower VIX volatility than the week of expiration or the week following expiration. Consistent with the idea that high volatility may be just around the corner during options expiration week, the VIX is least likely to spike to the downside during the week before options expiration – by a large margin. The VIX will spike to the upside more often than other weeks, but the combined upside and downside volatility of the VIX on the week before expiration is the lowest of the three weeks I examined. The average gain on the VIX of 1.4% during this week is the highest of the three weeks, but is not meaningfully higher than the 0.2% of the other weeks, particularly if one backs out the historically poor performance during options expiration week.

The week following options expiration
One surprising finding was that the VIX is more likely to spike up or down in the week following expiration than any other week. The probability of an upside spike of 15% or more in the VIX was significantly higher in this week than any other week. The pattern held true for downside spikes as well, with the VIX significantly more volatile to the downside than the week before options expiration and slightly more likely to spike down than during options expiration week. In terms of relative performance, the upside and downside spikes seem to cancel each other out as the VIX is up an average of 0.8% during this week and 0.4% in the other weeks.

Additional comments

For those who are not familiar with the quirky personality of the VIX, this might be a good time to keep in mind that just looking from weekly close to weekly close, you can expect a price change of at least 10% -- either up or down – in 30% of all weeks and a move of 20% or more on 7% of all weeks. On average, VIX moves down have been much more frequent during the past two decades than moves to the upside, with moves of 20% or more from week to week occurring at a rate of four times more frequently to the downside than to the upside.

Current VIX position
With the fifth consecutive week of dropping prices and a 10.15 close last Friday, I am mildly bullish on the VIX right now and would look to aggressively buy VIX calls should the VIX slip to the 9.75 mark.

Sunday, January 7, 2007

VIX and More: An Introduction

As the first entry in what I expect will be a relatively long-lived venture, I am going to step back a minute and provide some context.

First, why do I care about the VIX? Is it a better indicator than some of the other calculations or market volatility or, more broadly, investor sentiment? The answer to those questions will be addressed in future entries, but unlike other sentiment indicators, one can trade options (since February 2006) and futures (since March 2004) on the VIX in a fairly liquid market, with 14 years of historical data to provide fodder for trading strategy development:

More importantly, even a cursory inspection of the VIX data shows that there is a strong tendency to revert to the mean. As a result, oscillators such as the CCI, Williams %R, and RSI, among others, are reliable in terms of calling tops and bottoms in the VIX. The bottom line is that this makes the VIX highly tradeable. For more information on publicly disclosed VIX trading strategies, check out:

Looking at the weekly and daily charts of the VIX,

you can see that big moves rarely last more than 2-3 weeks before reverting to the mean. For this reason, as a general rule, it is a good idea to start harvesting profits after no less than 3-4 days and look to close out positions in no more than 10-20 trading days.

Where does the VIX currently stand? Pulling back to the 30,000 foot level and looking at the VIX monthly chart
Monthly VIX

we identify four macro-periods:

  1. relatively low, flat volatility for 3 years from 1/93 to 1/96
  2. increasing volatility for 1 ¾ years from 1/96 to 9/97
  3. a five year period of extreme volatility from 9/97 to 9/02
  4. the current period of decreasing volatility that began in 4/02 and continues to the present

The macro question is when the current trend of decreasing volatility will end and if we will see volatility back in the 20s for more than a couple of days a year.

The micro perspective, which I use for trading, looks back at most 3-6 months, typically more like 10-20 days. Since the mid-December bottom, the VIX has been trending up, but without the dramatic spike that pulls it significantly away from various moving averages. Right now I am slightly bearish on the VIX and would look to buy puts if the VIX moves over 13.30 in the next few days.

Having touched lightly on several topics above, I intend to drill down in more detail in the coming weeks.

Some future topics I am also aiming to cover here:

  1. Trading the VIX around options expiration week
  2. Trading the VIX near FOMC decision days
  3. The VIX as a contrary indicator
  4. Using the VIX in concert with other indicators

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