Tuesday, January 15, 2008

When Volatility and Put to Call Activity Diverges

A reader asked whether I think tracking the ratio of the VIX to the ISEE has any value in terms of market timing.

I track indicators that sum relative volatility and put to call activity as well as a couple that examine the ratio of volatility to put to call action. For the most part, these two categories of sentiment indicators tend to confirm each other. Further, when volatility and put to call numbers signal the same extreme sentiment across both dimensions at the same time – as is usually the case – this dramatically increases the expected value of a number of contrarian setups.

Strong divergences between volatility and put to call activity are relatively rare. I did blog about this type of divergence at the end of May 2007, just before the VIX started upward on a path that would see it triple in less than three months. For the record, my conclusion at that time, which continues to be supported by the data I collect, is that “high readings of volatility relative to put to call data are generally bullish for the broad markets while high readings of put to call data relative to volatility are generally bearish for the broad markets.”

In looking at the ISEE numbers, keep in mind that this is a call to put ratio, so that if one wishes to compare the VIX to the ISEE, it is best to invert one of the numbers before putting them under a microscope and studying their Brownian motion


Anonymous said...

Hey Bill,
I asked Adam today about his thoughts on the inverse ETF that are the rage and if they are causing a dampening effect on VIX. You have any research into the VIX relative to inverse ETF's? Could former put buyers be instead loading up on the inverse/double inverse funds as a hedge??? Instead of buying puts on one index (SPX) to hedge a highly correlated basket of equities one could get really specific and find higher correlations using a basket of inverse ETFs to more specifically hedge a basket of stocks??? Seems like a lot of work but isnt that what quants do--look for a better hedge/edge?? Something strange is going on in VIX land.

Bill Luby said...

If any readers have a good hypothesis that might answer these questions, I'd love to hear your thinking...

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