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Food for Thought for Volatility Contrarians

Observations (and caveats) surrounding the recent VIX underperformance

by 9/23/2013 7:19 AM
Stocks quoted in this article:

Well, we got our non-taper. The market exploded and the CBOE Volatility Index (VIX) and iPath S&P 500 VIX Short Term Futures TM ETN (VXX) tanked. No surprise there, as far as the volatility indices are concerned. But then a funny thing happened. The market gave back a bit of its gains. But the volatility indices? Well. I got this question on Twitter on Friday.

Why is the VXX behaving this way last couple days? Been creamed as market moved higher and down last 2 days while market is down.

The short answer is that these relationships are all a bit imperfect. VIX itself has something like a negative 0.60 to negative 0.65 correlation to the S&P 500 Index (SPX). In English, that means it catches a shade under two-thirds of the inverse of the market. So at best, we're going to see some discrepancies about one-third of the time.

VXX tracks about half the move in the VIX in a given day, but there are variables there too. VIX futures don't always move in tandem with VIX itself. So there is a wide range of possible relative reactions. Remember always, the VXX is a normalized VIX future, which is a derivative of VIX, which proxies the volatility of SPX options, which are derivatives themselves. That's a long game of telephone when you try to relate the movement in one end to the movement at the other end.

But there is some meaning when we see the action of the VIX diverge from our expectations based on the action in the SPX. If you hold a contrarian take on VIX, you should view action with a bullish lens if VIX overreacts positively to the market. Say SPX goes down a couple points and the VIX pops 10%. All things being equal, that's a major overreaction and a sign of a spike in fear. That's bullish for the market if you believe in fading that fear.

Conversely, if the VIX underperforms, it should get you bearish on the market. And VIX did underperform these last couple of trading days. So all things being equal, that should get VIX contrarians bearish, right?

Well, here come the caveats. All things are not equal. They're never equal. In individual stocks, options volatility spikes ahead of most earnings reports, and then declines after the report, almost regardless of the action in the underlying stock. That's because ahead of expected news, options price in the possibility of a gap move. And then once the news is out, the probability of a gap move decreases substantially. The market as a whole sees the same dynamic, just substitute "wildly hyped anticipation of Fed announcement" for "earnings report."

I know 14-15 VIX doesn't seem like options are bid up, but in reality they did have a bit of extra Big-Ben premium built in. Remember realized volatility was only about 6.5 the other day, so in the absence of expected news, VIX might have been 12 or 13 instead.

As it turns out, options were correct to bid up a bit into the Fed, as we did see a nice move. And it's perfectly logical for options volatility to contract a bit afterwards. What's more, options volatility contracts anyway on most Fridays, as traders lower bids to avoid paying too much weekend time decay.

Finally, complacency isn't a great indicator under even under the best of circumstances. Fear spikes and fades, apathy lingers. It's very hard to time the market based on too much disinterest.

Throw it all together, and I really wouldn't read anything into a couple days of VIX underperformance post-news. Go on to the VXX level, and you have all this, minus the weekend effect, but plus the contango drag, and I'm just not sure there's much signal.

Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.

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