A Refreshing Take On How to Use the VIX

Will the VIX test single digits?

May 12, 2015 at 9:09 AM
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Everybody and their guru predicts a CBOE Volatility Index (VIX) rally sometime relatively soon. The next guy that gets on TV predicting drifting or even flat volatility will be the first guy. So, maybe we need to find this Rick Rouse from InvestorPlace and get him on CNBC! Here’s what he has to say:

"My chart work is telling me that the S&P 500 could make a run at 2,200 to 2,300 over the next six to 12 months and, if it does, it is very likely that the VIX will be below $10. This will certainly have the talking heads clamoring and questioning what is wrong with the volatility index ... [T]he VIX has fallen below 10 on only a few occasions.

"If and when the VIX does test $10 to $9, I would then become cautious myself on a market pullback, correction or selloff. It is possible that the VIX could hold $10 for a few weeks, but it will have become a hot topic, if not the hottest story, by then, at which point it will be time to go."

I don't necessarily agree that VIX will get to single digits. There's a bit of a floor in implied vol where it doesn't become economically viable to short options. Yes, realized vol can and does get lower than that. We've seen fulls of "3" at times over the past year. But, it's tough to convince traders that those lows will persist going forward, and as such it's tough to convince anyone to sell options at implied vols below 10.

In order to maintain a 10 vol, you'd need the S&P 500 Index (SPX) to have ranges of about 0.6% on two-thirds of trading days. That's really not a high bar. I'm not saying we won't see realized vol that low (we often do), just that you also have to convince "the market" that realized vol that low will persist going forward. And that's not something that happens terribly often.

But hey, it's a refreshingly contrarian opinion. I do believe that there's a good chance we break this current range to the upside, if for no other reason than it's the less-expected outcome. We're told over and over again about high earnings multiples, future interest rate hikes, sluggish economic numbers, et al. Bullish sentiment tends to lag, even in rallies. So, we could definitely see a rise on a "Wall of Worry."

Yes, I know I just wrote we're a bit overdue for an overbought VIX. But, none of this is mutually exclusive. We can see a short-term VIX pop within a longer-term flat or drifting VIX. In fact, we often do. It happened as recently as last year. VIX went to near single digits in early July and then shot up to overbought two weeks later.

I guess the moral of the story is most every call will eventually prove correct. Long-term trend changes are tough to time. And so are short-term blips, for that matter. We know both will happen, we just never can know exactly when.

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

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