Trader’s Narrative

Here’s an interesting article from Barron’s Online today: The Best Way to Use the VIX

Bill Luby, editor of the blog, VIX and More, said, “A classic misuse of the VIX is as a market timing signal. The VIX is generally negatively correlated with the broad market indices, but this correlation waxes and wanes.”

This throws conventional wisdom a curveball right away.

He continued, “Further, investors tend to believe that absolute numbers for the VIX are sacrosanct, so that a VIX of 30 or 50 or 70 starts to take on a special significance [see Chart 1]. For the most part, my research and experience suggests that absolute VIX levels are much less meaningful than the current level of the VIX in relation to recent levels.”

This is something I’ve outlined more than a few times:

• Volatility Spikes Higher (But Not High Enough)
• VIX’s Distance From Moving Average Is Bullish
• The Volatility Index: It’s All Relative
• The Heartbeat of the Stock Market Goes Thump

Although looking at volatility through the prism of relative performance helps us to understand it better, it can still at times be elusive. This chapter of market history is just one of those times. What we have seen recently is such an outlier that even when we look at relative volatility, rather than absolute volatility, we still see an aberration worthy of extreme value theory. With one exception.

I looked at the CBOE NASDAQ volatility index (VXN) and compared it to its simple 150 day moving average. Here is where we are now relative to where we’ve been before:

In 1998, the distance of the VXN from its 150 day moving average peaked on early October, just as the market made the final low. In 2000, it peaked in mid April but the market was far from a lasting low. And that brings us to 2008 when the relative VXN peaked in late October.

My hunch is that during “normal” markets, the VIX and VXN provide great signals. But removed from a stair stepping bull market, things can easily become extreme and lose meaning. What we saw in early 2000 was the pricking of an asset bubble and its consequences. What we are seeing this year is the pricking of a credit bubble and its consequences. Until we once again see “normal” markets, the volatility gauges will be an interesting sideshow.

Usually I try and avoid pontificating on the VIX because Bill over at VIX & More does a fantastic job of examining volatility in all its shapes and sizes. You could say that he picks up the VIX by its scrawny neck and bashes it about until the poor statistical measure gives up every drop of market insight it has and more. If you haven’t yet to discover his blog, I highly recommend you read it regularly.

I’m sure that Bill will excuse this slight incursion…

As the market fell yesterday, it caused the volatility (VIX) to spike higher and close slightly under 19. This is high but not high enough to show real fear.

In the past few years, when the VIX has reached 20 and above, we tend to find some sort of footing and rebound (see graph below). The most recent example of this occurred in early March 2007 when the VIX hit an intra-day high of just above 20.

I find it a bit strange to talk about volatility highs or spikes in the 20’s range. Not that long ago that was nothing! Real volatility spikes registered in the mid 40’s. Things sure have changed. If we then go back even further in time, to the mid 1990’s, we again find ourselves in today’s volatility scenario where 20 is high enough to cause short term and intermediate term bottoms.

Are We There Yet?
This is why we can’t only look at the VIX’s nominal readings. Over time the landscape changes and what once was considered “high” is no more. A simple way to iron out such possible distortions is to look at the distance that the VIX is from some daily moving average (see bottom most graph).

I like the 50 moving average but you can use any reasonable number really. Putting the VIX through this moving average filter, we see that it still isn’t high enough. It is close. But just… ehn, ehn, under it.

Which means that we could very well spike higher from here and fall further down. But the good news is that theoretically, the VIX doesn’t have to go much higher or the market fall much further before we find an extreme reading from the VIX.

Causes of Low Volatility
For those curious enough to wonder why the volatility is so muted, everyone has their theories. Mine is that it is due to mainly two new forces:

One, the rise of the program buying/selling which parses prices and movement into finer and finer increments to squeeze out alpha. And two, the rise of gargantuan amounts of money to eek out bond like yields (in a low yield environment) from selling options. The massive amounts of options which these funds have to sell day in, day out increases supply and therefore, volatility.

Click to Enlarge Graph:

Now that you’re done reading my take on things VIX-wise, go read what Bill has to say.