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Volatility Continues To Melt Lower at Trader’s Narrative





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The continuous slow motion melting of the volatility index (CBOE’s VIX) has gotten a lot of attention lately. I briefly mentioned it last month when I pointed out that the VIX has shrunk to its lowest in 6 months. Now we are below 30 - which is not really an important milestone, except that it is a nice round number. And that we are now back where we were in September 2008 just around the time that Lehman Bros. blowed up good taking the rest of the market with it.

Here’s a long term chart of the VIX showing the significant support that it broke through to the downside:

volatility index VIX long term chart support line

VIX zoom May 2009While most people with some familiarity with the VIX automatically assume this means there’s a bull market around the corner, the truth is more nuanced. Here’s a zoomed in chart of the VIX showing that while we gapped lower and closed higher for the day, we still closed below 30.

My hunch is that there are two things happening right now. One is the always present movement of the VIX which is normal and derives from the options market. The other is the return to normalcy from an insane period of time. Believe it or not, there was a time that 30 was considered extreme. And yet, here we are approaching it from the other side!

According to Interactive Brokers: This brief analysis highlights the springboard rally for stocks as overly pessimistic conditions fade. As they do, watch for investors to overdo the volatility decline. As we keep noting, we’re still not out of the woods yet. Also, according to IB, there are 2.1 million VIX contracts expiring tomorrow with more than a third being calls (people betting that the VIX would go higher).

As Eddy helpfully pointed out:

Since 1990, when the VIX is below 15 (about 31% of the time), the S&P’s annualized return is 7.8%.
When the VIX is between 15 and 20 (27% of the time), the S&P’s annualized return is 2.8%.
When the VIX is between 20 and 25 (22% of the time), the S&P’s annualized return is -1.5%.
When the VIX is over 25 (20% of the time), the S&P’s annualized return is 11.1%.
To the extent there’s a tipping point, it seems to be a VIX of 13. Above 13, the S&P shows an annualized return of 3.0%, below 13 it jumps to 14.1%. However, 13 is a very low VIX reading; it’s been below 13 about 18% of the time.

Below is an CNBC interview with Carter Worth, chief market technician at Oppenheimer Asset Management. Worth provides some perspective by mentioning that the average level for the VIX since its founding is around 19. Watch the video to see why Worth thinks the VIX’s trend is about to change:



Also, check out Barron’s: Don’t Get Euphoric About a Falling VIX

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One Response to “Volatility Continues To Melt Lower”  

  1. 1 PazzoMundo

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    Babak,

    I take your point about the expiry tomorrow and the potential for investors to overdo the volatility decline. I’m of the view that a snap back above 30 will confirm that last week was the top. Of course the alternative is that the S&P500 can make a new high in the near term and its off to the races again. I had a bit of a look at the VIX today (http://pazzomundo.blogspot.com/) if you’re interested…In a sense, I’m following the Evil Speculator’s lead - he has a watch on a VIX sell signal at the moment.

    Cheers

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