Schaeffer's Trading Floor Blog

About That Low VIX...

Is the VIX merely reacting to the bullish price action?

by 5/28/2014 7:09 AM
Stocks quoted in this article:

About that low CBOE Volatility Index (VIX) being bullish, I really want to clarify some points.

The important takeaway is that it's not bullish that VIX is so low. Rather, VIX is so low because the market is acting so bullishly.

We like to remind everyone that VIX is a volatility index, and not an inverse exchange-traded fund (ETF). But the reality is that on a day-over-day basis, it really does act like an inverse ETF. Here's the yearly correlation between the daily move in VIX vs. the daily move in the SPDR S&P 500 ETF Trust (SPY) over the last decade-plus:

VIX and SPY annual correlation since 2004

In 2014, we're at the high end of a generally high series of numbers. It's safe to say that the move in SPY pretty much accounts for the inverse of the lion's share of the move in VIX. In 2014, the SPY move can "explain" over 75% of the price action in VIX (you have to square the correlation). That's gigantic if you think about it, as there are times when options price in anticipation of future news and don't necessarily move with SPY. Not to mention there are weekends and holidays where VIX may reflect time decay, et. al.

The point is that VIX in 2014 clearly measures very little in the way of future anticipation. It's simply reacting to the price action of the day. And as long as that price action remains muted and up, there's really no reason for VIX to do anything but drift.

It's complacent in the sense that there's clearly no particular fear of an imminent volatility spike. But it's also realistic in the sense that there's no reason it really should get all worried about that hypothetical spike. It costs money to use options or volatility to bet on a market decline, either in the form of time decay on a basic option or "contango decay" in the case of a volatility exchange-traded note (ETN) like the iPath S&P 500 VIX Short-Term Futures ETN (VXX). VIX futures all carry premiums, so it costs money there, too, as they drift over time toward parity.

What's more, even at an 11 full, VIX is not "cheap" vs. the realized volatility (RV) backdrop in the market. In fact, 10-day RV in SPY is about 8.8, and even that low number overstates the actual volatility SPY has had, given its relatively large range on May 15. When that leaves the calculation in a few days, 10-day RV will "print" even lower.

So, no, low VIX isn't at all "bullish" for the market. It's simply a condition that exists concurrent with a low-volatility rally like the one we're seeing.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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