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Preparing for the VIX 'Super Spike'

The VIX will eventually spike the question is, when?

by 6/18/2014 7:32 AM
Stocks quoted in this article:

Is the CBOE Volatility Index (VIX) poised for a "Super Spike?" That's the opinion of one "Uber Bear" as per The Wall Street Journal:

Lots of investors assume that the quiet in the stock market won't last long. But one noted bear on stocks is reiterating her two-year old call for a "super spike" up in volatility, the likes of which haven't been seen since the depths of the financial crisis.

Abigail Doolittle, founder of Peak Theories Research, wrote in a note to clients Friday that, like many technicians, she believes the CBOE Market Volatility Index, or VIX, could double off recent lows to within the 18-to-22 range, just like it has several times the last couple years.

Ms. Doolittle noted that VIX bulls point to a "falling wedge" pattern that has been building in the short-term daily charts since early February, characterized by steadily lower highs and lower lows. They argue, she said, that the current pattern looks very much like the ones that preceded upward spikes in the VIX to around 18 to 22 and pullbacks in stocks in December 2012, June and October of 2013 and February 2014. Those VIX highs were seen around pullbacks in the S&P 500 ranging from 4.1% in October 2013 and 7.7% in November 2012.

Here's a deep thought. If Uber itself goes public and you hate the stock, are you then an uber-Uber Bear?

OK, I totally digress.

I'm far from an Uber-Bear, but I agree with her call. The VIX will most definitely see a spike. And if you measure it in percentage terms, it will look wildly impressive. A 20 VIX is historically average, and yet when we get there, it will represent a near-doubling off the bottom.

In fact, I'll say there's a 100% certainty we see something that will fit her definition of a super spike. I will also say that this "call" is a perfect sound bite for both the media and research clients, but it has little financial value.

That's because it's all about the timing.

The VIX meanders around a mean and then spikes about three or four times in the typical year. It looks very dormant now, but sometime in the next few months, we're very likely to see something that upsets the apple cart. And, if it's very unsettling, the VIX will soar.

So, why not just buy VIX futures or VIX calls or S&P 500 Index (SPX) puts now? Well, as we note what seems like every day, there's time value associated with every downside bet. If you buy a VIX future now, you're paying a premium to actual VIX.

Here's how the current term structure looks, courtesy of VIX Central:

Term Structure of VIX

The more time you want on your "bet," the more it costs.

If you buy VIX calls, you're paying the standard options premium on top of the future itself, already pricing in a VIX rally. And on standard SPX puts, you're paying a premium as well.

All these trades will work out spectacularly if VIX starts spiking today or tomorrow. But, if the spike happens in a month or three, your play will either have expired or be quite a bit underwater, and you need that spike just to hopefully get back to even.

My point is that of course VIX is not staying around 12 forever. Profiting from that knowledge is an entirely different question. I'd personally rather miss the bottom in VIX and wait until there's more hope of a volatility spike than sit with a losing position that eventually pans out.

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

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