VIX Drops Below 40

The last time the VIX was below 40.00 was on October 2, 2008

Watch the Baltic Dry Index in 2009

In 2009 investors will be scanning the globe for signs of economic recovery or deterioration. Among the many tools they should be watching in order to gauge the strength of global trade is the Baltic Dry Index (BDI.) The Baltic Dry Index measures shipping rates for dry bulk carriers that carry commodities such as coal, iron and other ores, cocoa, grains, phosphates, fertilizers, animal feeds, etc. In short, the BDI is an excellent proxy for global trade.

In the chart below, note how the BDI peaked after the S&P 500 index did in 2007 and bottomed after the SPX last month. The BDI may not be a leading indicator, but it is an important way to confirm whether moves in global equities are being reflected in an increase in global shipping. If the BDI fails to rally in 2009, be skeptical of any rally in stocks.

For those who are interested in following stocks of some of the leading dry bulk carriers, a good place to start is with Diana Shipping (DSX), DryShips (DRYS), and Excel Maritime Carriers (EXM).

[source: StockCharts]

VIX Close of 41.63 Is Lowest in Three Months

The last time the VIX closed below 42.00 was way back on October 1^st, when the VIX closed at 39.81.

Before anyone gets excited about the possibility of the VIX back in the 30s, I should note that the VIX futures continue to reflect expectations of a rising VIX over the course of at least the next 2-3 months. Today’s VIX January futures settled at 44.18 and the February futures settled at 45.08. Futures for August through October are now priced in the 37-38 range, however, suggesting that volatility expectations are being lowered for the second half of 2009.

Top Posts of 2008

Here are the top posts of 2008, based on the number of unique readers:

1. Ten Things Everyone Should Know About the VIX
2. Prediction: Direxion Triple ETFs Will Revolutionize Day Trading
3. What Is High Implied Volatility?
4. Volatility History Lesson: 1987
5. VIX November Futures
6. The VIX, VXV and Volatility Expectations
7. Strong Bear Signal from VIX:VXV Ratio
8. Arms Index Going Back to 1992
9. VXO Chart from 1987-1988 and Explanation of VIX vs. VXO
10. The VIX-SPX 30 Day Historical Volatility Spread and Performance
11. The Fallacy of the Bearish First Five Days
12. Fear and Flight to Safety
13. Overview of the U.S. Volatility Indices
14. Rare Batman Pattern Forming in the VIX
15. The Evolution of the Volatility Index Family Tree
16. Can Markets Bottom Without a VIX Spike?
17. VIX Numbers and Overbought Signals
18. The Significance of Double Tops in the VIX
19. VIX Spikes and the 2002 Market Bottom
20. Equities or Commodities?
21. SPY Put Volume Study
22. A Long-Term View of the Put to Call Ratio
23. The Rising Popularity of XLF Options
24. ISE Implied Volatility Charts
25. Is the Fear Bubble Bursting?

For those who may be interested, last year I compiled a similar Top 25 Most Read Posts of 2007.

ISEE Equity Call to Put Ratio and the End of the Year

Further to this morning's ISEE Put to Call Ratio at Highest Level in 16 Weeks, the ISEE equities only call to put ratio finishes at 198 -- the highest close since May 16, 2008.

The last time this index had back to back closes this high was 12/28 and 12/31/07.

It is worth noting that the only other year for which the ISEE equity only data is broken out is 2006; that year also had some higher than normal readings on the last four trading days of the year.

Given the brief holiday track record of the ISEE, my suggestion is not to dismiss the ISEE equity only data out of hand, but to take it with a grain of salt.

ISEE Equity Call to Put Ratio at Highest Level in 16 Weeks

The ISEE equity call to put ratio hit a 16 week high of 189 on Friday, as investors showed a strong preference for calls over puts. Today that ratio is even higher, at 215 as of 11:30 a.m. ET.

Trading is light so far and extreme values in the ISEE have a tendency to revert to the mean (146) as the day wears on, but coming on the heels of Friday’s high number, I believe the ISEE numbers should bear watching throughout the day.

For the record, the last time the ISEE equity call to put ratio was over 200 in a single session was back in the middle of May. At that time, the markets were just in the process of putting in a post-March top.

[source: International Securities Exchange]

End of Year Volatility Links

Now that the VIX is down more than 50% from its October peak, it seems as if everyone wants to talk about the VIX and volatility.

So…for the last time in 2008, here are some of the recent posts from around the blogosphere (with a heavy volatility flavor) that I have been chewing on for the past week or so:

• Credit Crisis – Signs of Progress (Prieur du Pressis, The Big Picture)
• Madoff’s Volatility (Felix Salmon)
• More Leverage (Adam Warner, Daily Options Report)
• Air Pocket Watch: November Hotel Occupancy (Paul Kedrosky, Infectious Greed)
• 2009: Already Looking Bleak (Mike Shedlock)
• Friday Market Sentiment (Headline Charts)
• Learning from Mistakes: The Short Sale Ban (Jeff Miller, A Dash of Insight)
• Spot the Difference in Volatility Levels (Peter Jacobson, Barron’s)
• The Relativity of Volatility & 100 Year Floods (Babak, Trader’s Narrative)
• The Volatility of the VIX: From Bear Panic to Barely Elevated (Brett Steenbarger, TraderFeed)
• Sentiment Surveys and the VIX (Peter Birchler, Stock Market Alchemy)
• Volatility, The VIX, S&P 500 and High Jump (Ian Woodward)
• Good Economic News for the Holidays: Volatility is Down (Ian Ayres, Freakonomics)
• Research Brief: Looking for Clues in Economic Volatility (James Picerno, The Capital Spectator)
• The Demand for Risk and a Macroeconomic Theory of Credit Default Swaps: Part I (Charles Davi, Derivative Dribble)
• Ideas for Volatile Times: Upside-Down Split-Strikes (Brian Overby, The Options Insider)
• Testing a Simple Index Covered Calls Strategy (CXO Advisory Group)
• International Long-Term Interest Rates (Bespoke Investment Group)
• ThinkorSwim ThinkAI (Emini Addict)

…a series of posts triggered by a Bloomberg article by Jeff Kearns and Michael Tsang’s VIX Fails to Forecast S&P 500 Drop, Loses Followers:

• Journalists Have a Responsibility Not to Get It Wrong (Mark Wolfinger, Options for Rookies)
• VIX Fails to Give You a Pony and Premature VIX Obituary Roundup (Condor Options)
• Bloomberg Says VIX Is Worthless (Don Fishback)
• VIX Searching for Its Mojo (Adam Warner, Daily Options Report)

…and VIX and More’s first mention in Barron’s:

• The Best Way to Use the VIX (Michael Kahn, Barron’s)

Chart of the Week: Gold

In a week in which most securities drifted lower on uninspired volume, gold was a notable exception, jumping 4.1% as tensions between India and Pakistan increasingly point toward the possibility of a military confrontation while violence in the Gaza Strip between Israel and Hamas is escalating.

Against the backdrop of potential conflict in either Gaza or the India-Pakistan region, gold surged above the critical 840 mark and ended the week at 871. As the uppermost of the two dashed black lines in the chart of the week shows, resistance from previous November-December 2007 highs was pierced this week. Gold also broke out of a down trending channel (solid black lines) this week and is now setting up for a possible large bullish move. If gold continues to rise, look for gold miners (GDX) to be even more volatile and likely outperform the commodity or the popular gold bullion ETF, GLD.

[source: StockCharts]

SPX Ten Day Historical Volatility at Lowest Level Since September 12

There are quite a few ways in which to measure historical volatility. Probably the most responsive of the time periods commonly measured is the 10 day historical volatility (HV) period, which covers the last 10 trading days. Variously referred to as statistical volatility, realized volatility, actual volatility, etc., the 10 day historical volatility measure for the SPX (dotted blue line in chart below) peaked on October 22^nd at just a fraction under the 100 level. On December 3^rd the 10 day HV was still holding strong at 89, but it has fallen precipitously over the course of the last three weeks and is down to just 35 as of Wednesday’s close and on target to dip as low as 33 or so today.

For comparison purposes, the 10 day HV in the SPX has not been below 35 since September 12^th, just prior to the Lehman bankruptcy.

The bottom line: while a VIX in the low 40s may look cheap at the moment, consider that the recent historical volatility in the SPX has been slightly more than three quarters of that represented by the VIX. Of course, the December holiday effect has artificially depressed volatility to some extent, but certainly cannot claim full responsibility for the drop in 10 day HV from 89 to 35.

[source: VIX and More]

The VIX Annual Cycle

Two years ago, when I was the only person reading this blog, I posted about VIX seasonal patterns in A Month By Month Look at the VIX. Since the original post I have received quite a few requests to update the chart with more recent data.

On the heels of yesterday’s VIX Holiday Crush, I am pleased to broaden the seasonal picture of the VIX with a current version of 19 years of VIX data as a composite annual cycle. The chart below has changed very little from the January 2007 version. In fact, 2008 followed the historical patterns established in previous years almost perfectly, with the VIX increasing in the January-March period, dropping through May and June, then spiking dramatically in September and October.

I have my doubts about whether this pattern will play out in future years, but the more times volatility wanders down this same seasonal path, the more time traders will be looking for a repeat in the following year.

[source: VIX and More]

VIX Holiday Crush

The VIX has been steadily declining during the month of December, from the high 60s on the first day of the month to the neighborhood of 42 as I write this.

Clearly the extraordinary measures taken by the government to pump liquidity into the system have been responsible for some of the shrinking volatility, but since I often talk about the holiday effect on volatility and frequently receive questions on the subject, I thought it would be a good day to share some of my research on the subject.

Since 1990, the month of December has averaged 21.05 trading days. The chart below captures each of those 21 trading days from 1990-2007 in composite form, with the mean for all December VIX values set at 100. In the chart, the pattern of decreasing volatility is most evident from the middle of the month to just before Christmas, during which period volatility drops from 2.4% above the December average (10^th trading day) to 4.8% below the December average (17^th trading day).

For the record, today is the 17^th trading day of December, which makes the the historical low point in volatility for December.

I will not go so far as to say the that calendar suggests today is likely to be the last time the VIX dips under 42 for awhile, but those with an interest in historical context may wish to prepare for an increase in volatility, as the holiday ‘calendar reversion’ effect wears off.

[source: VIX and More]

The VIX, Lehman Brothers, and Forecasting

Jeff Kearns and Michael Tsang of Bloomberg have an article out today (VIX Fails to Forecast S&P 500 Drop, Loses Followers) in which the authors contend that largely because the VIX failed to predict the October losses in the S&P 500 index (SPX), the VIX is no longer considered to be an accurate gauge of future market activity.

One of the central claims made by Kearns and Tsang regarding the lack of effectiveness of the VIX is stated as follows:

“On Sept. 11, less than a week before New York-based Lehman Brothers Holdings Inc. went bankrupt and four days after the government takeovers of Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the VIX closed at 24.39. That meant traders bet the S&P 500 wouldn’t fluctuate more than 24.39 percent on an annualized basis, or about 7 percent in the next 30 days, and implied a range for the index of 1,161.11 to 1,336.99.

One month later, on Oct. 10, the S&P 500 closed at 899.22, or a record 23 percent lower than what the VIX predicted.”

As fellow blogger Don Fishback was quick to point out, the VIX calculation actually estimates one standard deviation of annualized 30 day volatility expectations in SPX options. That standard deviation, of course, is meant to capture 68.3% of the Gaussian or normal distribution of prices. In fact, the distribution of VIX prices does not follow a normal distribution, but even if it did, the movements from September 11^th to October 10^th would not be that statistically improbable.

Some quick comments on the math involved here. Using a VIX of 24.39, the conversion of an annualized volatility of 24.39% to 30 day volatility yields a 30 day volatility of 7.04%. Two standard deviations translate into a 30 day volatility of +/- 14.08% and should cover about 95.5% of the normal distribution (I am assuming a normal distribution for the sake of mathematical simplicity). Three standard deviations increase the range of expected volatility to +/- 21.12% and should capture about 99.7% of the normal distribution. In fact, the 99.9% boundary for the normal distribution is 3.29 standard deviations and translates into expectations of an SPX move of 23.16%, about on par with what transpired. So, given that an event which falls outside of 99.9% probability distribution happens once every 1000 instances. Rare indeed, but not unfathomable.

Of course there are many ways in which to utilize the VIX to aid in market timing. Consider that the nature of the VIX calculation is such that the VIX acts as an unbounded oscillator whose values are derived from prices paid for options on the SPX. Like most oscillators, traders tend to use extreme values as opportunities to bet on a reversion to the mean.

A good deal of the difficulty in understanding the movements of the VIX is that some of the dominant patterns are different over the course of different time horizons. For instance, in the short-term, the VIX commonly spikes and mean reverts. Looking at the intermediate term, the VIX frequently establishes strong trends; and in the long term, the VIX has a tendency to move in cycles of 2-4 years. For the month of September and most of the month of October, the VIX was in an uncharacteristically strong sustained uptrend.

Part of the reason for the sharp move in the VIX during September and October is that it is highly dependent upon macroeconomic and fundamental events that help to shape investor perceptions of uncertainty, risk and fear. In the week leading up to the Lehman Brothers bankruptcy, for instance, very few investors believed that the government was prepared to let Lehman fail. Additionally, in retrospect is seems as if those who did believe failure was an option did not comprehend the nature of the systemic reverberations that a Lehman bankruptcy would trigger.

The bottom line is that during the second week in September, the VIX was pricing in a very low probability of a Lehman Brothers bankruptcy. Perhaps more important, investors were also assigning a significantly lower systemic threat potential as a result of the dominoes associated with a Lehman bankruptcy.

Ultimately, it took a full six weeks of a steadily trending VIX for the market to fully price in the global systemic risks associated with the sequence of events that began with the Lehman Brothers bankruptcy.

Consider that the prices and implied volatilities of SPX options have to account not just for the probabilities associated with various future scenarios, but also the magnitude of the impact of those scenarios on the stock market. For this reason, even while some of the probabilities may not have varied significantly from day to day during September and October, as the magnitude of the financial crisis was slowly revealed, the VIX continued to ratchet higher – and investors reacted to a rising VIX with increasing alarm.

Getting back to the question posed by Kearns and Tsang, yes the VIX underestimated future volatility back on September 11^th. At that time, the prediction of a four year flood was consistent with mainstream thinking. Very few observers anticipated the SPX falling below 800 by Thanksgiving.

As the year winds down, I will have more about what we learned about volatility in 2008 and what some of the implications are for 2009 and beyond.

Recognition for VIX and More

It is always nice to be acknowledged for the contributions you make, but it is particularly heartening when that recognition comes from a respected peer in the field. For that reason, I was pleased to see that Condor Options has included VIX and More in its list of the Top Finance Blogs of 2008.

The recognition is even more meaningful when I see the esteemed company this blog has on the list:

• Ultimi Barbarorum
• Quantifiable Edges
• MarketSci
• Daily Options Report

While these should all be familiar names to VIX and More readers, I do not believe I have yet featured the work of Ultimi Barbarorum on the blog. If so this omission is accidental, as Ultimi Barbarorum is a true thinking man’s blog in which the reader is treated to one side of the author’s ongoing dialogue with Baruch Spinoza. What could be a better way to pay tribute to the closet philosopher in all of us?

Chart of the Week: Fed Funds Rate Drops to 0.11%

Thanks to the Federal Reserve’s decision to drop their target Fed Funds rate to an all-time record of 0.00% to 0.25%, the subject of this week’s chart of the week is a no brainer.

The Fed has 55 years of Fed Funds rate data and I have chosen to highlight not the target rate announced by the FOMC, but the daily effective federal funds rate, which is a volume-weighted average of rates on trades arranged by major brokers.

Not surprisingly, Friday’s effective Fed Funds rate of 0.11% is a record low, but that record was actually established on December 10^th and tied again on Friday.

For history buffs, the record high of 22.36% dates back to July 22, 1981. The average Fed Funds rate since 1954 is 5.62%.

[source: Federal Reserve Bank, VIX and More]

VIX Drops Below 42; VIX Calls in Play

The range-bound action in equities over the last few weeks has brought us something we have not seen since October 3^rd: a VIX below 42.

With the VIX futures for January and February still trading in the 47-48 range, the consensus opinion is that a 42 is not sustainable. In fact, supporting that opinion is the flurry of activity in the January 70 and 75 calls in the past few minutes, as speculators (and perhaps hedgers) jump at the pre-Christmas sale prices on VIX options.

The graphic below summarizes the action in the VIX January options, with almost all of the action in the January 75 calls coming as I type this.

[source: optionsXpress]