Schaeffer's Trading Floor Blog

Viewing the VIX Through a Contrarian Lens

Skepticism is swelling on even the mildest of sell-offs

by 7/15/2014 7:42 AM
Stocks quoted in this article:

Maybe sentiment in the options world is worth more than I thought. Bloomberg Businessweek had this to say yesterday:

Investors have been building up protection against potential market pullbacks as both U.S. and European stock markets trade near their highs of the year. The S&P 500, which reached the highest price-to-earnings valuation since 2010 at its last record, has not had a drop of 10 percent in more than two years.

Traders own 2.1 bearish options on the S&P 500 for every bullish one, around the most since 2008. About 3.7 options betting on upside in the VIX are owned for every one wagering on its decline, the highest call-to-put ratio for the contracts since before the financial crisis.

Options betting on a 10 percent drop in the S&P 500 cost 7.56 points more than ones wagering on a 10 percent rise, according to six-month data compiled by Bloomberg. That's around the widest spread in a year, indicating that demand has picked up for protection against a pullback in equities.

If that's how people felt before the financial meltdown, then we must be on the brink of another one, right? Maybe I'm reading between the lines, but that's the takeaway I get from the piece. Everyone they quote sounds like they're prepping for the next volatility spike.

And, of course, that may happen. But let's keep a few things in mind.

We're talking a sample size of 1 here. Tradable CBOE Volatility Index (VIX) products haven't existed for all that long. Their lifespan encompasses a calm market, followed by an implosion, followed by a recovery characterized by perpetually declining volatility. The iPath S&P 500 VIX Short-Term Futures ETN (VXX) has seen only the recovery/declining-volatility part.

So I wouldn't read all that much on past history here.

Sentiment interpretation has existed forever, though. Back before 2008, we used to view options indicators through a contrarian lens. High volatility and a rush into puts was considered bullish on a contrary basis. Some people, including yours truly, still feel that way.

I especially feel that way when it shows a desire to fade the larger trend. And that's exactly what we have right now.

The VIX itself hasn't gotten overbought; it's still very low. But clearly the underlying sentiment belies that everyone wants to buy downside puts and cheap-dollar VIX calls -- everyone and their day-trading dentist want to get in shape for the inevitable decline. And there's nothing at all wrong with that; it's correct to have discipline and it's natural to anticipate that the rally won't last forever. It's just that if too many people feel that way and act on it, it tends to reduce the odds that those actions were correct.

Turns tend to happen precisely when the fewest people possible expect them and adjust their portfolios accordingly.

What I see in all this is an excess of skepticism about the rally and the relative ease to hedge, given the still-cheap VIX. Again, it's hard to argue with wanting to get defensive, I just think that on the margins it's a bullish tell. Especially given that we saw this action in response to the most tame of sell-offs.

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

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