Diary of a Financier

VIX Crumbling

In Capital Markets on Tue 13 Dec 2011 at 10:25

The VIX has crumbled today, down to 23.30 (-9%) as of print. 23. That’s not indicative of much fear. Is a VIX print of 23 predictive of an unpcoming market rally or misrepresentative of the current atmosphere?

As I’ve said before, VIX measures “fear” using a calculation of option premia on singlename equities. For example, VIX extracts the premium paid by an investor who bought a long put (or sell-short call) on GE common stock–usually a hedge for a long position on the underlying stock. I repeat: VIX is very much a coincident indicator and increasingly a reflection of the “dumb [retail] money”:

I’ve always held that the VIX is an inaccurate gauge of volatility. Philosophically, I’d have to ascribe that to the reflexive feedback loop wrought from its mainstream acceptance. I often opt for Implied Correlation (KCJ), but even that has gained wider acceptance and therefore eroded predictive powers.

(Remember that: “I often opt for Implied Correlation.”) I see LIBOR surging ahead unopposed. I see Eurodollar Swap Futures fading the global, coordinated Central Bank intervention. I see EURUSD collapsing. I saw overwhelming demand at last week’s 3-year US T-Bill auction. These points all indicate a crowding out of EUR into USD, of which there’s apparently a severe shortage–despite the Fed’s generous swap lines.

Nevertheless SPX 1232, VIX 23. To the retail investor, markets are like that duck from the old adage: calm to the onlooker’s eye, but treading furiously underwater to stay afloat.

VIX at 23 is a real dislocation in my eyes–far more out of sync than even SPX 1232. I can’t get over that. I had to look at other fear gauges to find confirmation of VIX’s plea, and there’s where I found the stress. Unlike VIX’s utilization of singlename options, Implied Correlation (ICJ) uses the option premium on index options. In other words, when institutional traders want to hedge SPX–not just GE–they use ICJ. The divergence between Implied Correlation & VIX is unprecedented as of today. In fact, the spread between the indices has levitated to an alltime high:

Implied Correlation v VIX- spread at alltime highs.

I’d be amiss to not acknowledge the spread spike in October 2010, which was proximately met by a SPX rally. However, I maintain that today’s US markets will remain in want of additional stimulus until Europe’s problems are settled.

I’d suggest that neither index had predictive powers, nor do the traders who utilize them. However, they all provide context, which suggests substantial risks remain, although the duck seems to be relaxedly going with the flow. The question remains where & when the risk will manifest, to wit I don’t expect anything before Christmas. In a brilliant alignment of technicals & fundamentals:

  1. The next reckoning hurdle arrives with Greek bond maturities on December 29 & 30–€5.23B & €715M respectively.
  2. VXX & VXZ divergence suggests more intermediate-term (VXZ) anxiety than front-month (VXX) in a kind of volatility curve contango.*
  3. I notice a short-term Bull Pennant/Cup & Handle has developed in SPX, the inverse of which EURUSD leads by about two trading days.
  4. SPX also exhibits a neat bull Head & Shoulders, with neckline around 1270.

The latter two points are exhibited below:

SPX- Bull H&S, Bull Pennant; EURUSD (inset)- Bear Pennant continuation confirmed.

–Romeo (*hattip Jeff Norman)

  1. Some VIX crumbling can be attributed to normal low December volatility. Note that the VIX futures curve is in contango; normally at elevated VIX levels like this it is inverted or at least flat. The VIX futures curve was inverted from August (when debt ceiling issues led to increased volatility) until the November VIX futures contract settled.

    • That’s a terrific point that I hope people read. I added that to my entry using VXX/VXZ divergence as an [imperfect] example, since I hadn’t the chance to check that out on the Bloomberg and post a chart of the futures curve. (I actually remember August’s inversion well, since I wrote a bit about it here.)
      So everyone knows: the VIX contango is steep out until May/June/July 2012, where the curve plateaus.

  2. By the way, the VIX curve’s suggestion that European unwind were to occur in May/June/July is rather timely for another reason: ECB’s LTRO has provided banks with a choice between 3 or 6 month* financing collateralized by banks’ sovereign assets–to promote liquidity in the banking system. Further, since having been shut out of the banking system, Greece has resorted to 3 & 6 month bond auctions to continually finance its operations.
    Recently, the ECB announced a relaxation of its collateral quality standards in conjunction with an extension of LTRO’s maturity schedule (36 months), to be implemented in two operations (12/21/11 & 2/29/12):

  3. […] cum Despondency), the VIX is really getting suppressed, exactly as I had surmised it would last week: Is a VIX print of 23 predictive of an unpcoming market rally or misrepresentative of the current […]


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