Time to Go Long the VIX?

03/05/2010 12:01 am EST

Focus: STRATEGIES

Adam Warner

Author, Options Volatility Trading

If you like to trade volatility, then you must have absolutely hated the past few weeks! As of Wednesday's close, the CBOE Volatility Index (VIX) had dropped 15 of the last 16 trading sessions.

That's the worst performance since the bull began in March 2009, according to The Pragmatic Capitalist. And, honestly, it's hard to imagine there are too many times in any market where we went 16 for 16.

In percentage terms, the VIX has dropped about 30% in a mere three weeks—not a pretty picture.


Click to Enlarge

Now, the obvious conclusion is that we got too complacent, too fast, which, on a contrary basis, is quite bearish. But alas, we have many caveats.

Extreme complacency does not provide as good a market timing signal as its evil cousin, extreme fear. While fear tends to resolve in a crescendo, complacency can just linger on for what seems like forever.

And it's unclear whether this particular options complacency is unjustified.

The VIX proxies the implied volatility of a hypothetical S&P 500 option with 30 days until expiration. Implied volatility represents the market's consensus estimate for the realized volatility of the underlying instrument itself, the S&P 500 (SPX), going forward.

Ten-day realized volatility in the SPX is now about 12. The VIX typically carries a three- to four-point premium to realized volatility, so a VIX around 19 is actually not cheap by this metric.

Of course, ten-day realized volatility looks backward, and 12 is on the low end of this year's range. But, by the same token, it's truly representative of the pace of the market lately.

Finally, we're using a bit of selective statistical analysis just looking at the VIX drop from 26 on February 8. The VIX didn't go from fair to cheap; it went from high to fair.

Remember back in January that the VIX lifted nearly 50% to 27 in two ugly market days. It then drifted back near 20 before popping quickly again to 26.

But for the VIX to sustain in the mid-20s, it needs the volatility of the market itself to pick up. And so far it hasn't, save for a few random days here and there.

Throw it all together and I really don't see the VIX signaling much of anything. A closing drop to the mid-18 level or lower would get us 10% below its ten-day moving average, which is somewhat bullish for the VIX and bearish for the market.

But even that indicator works better as a countertrend. In other words, a VIX 10% above the ten-day simple moving average within an intermediate-term bull move is a decent buy signal, while 10% below the ten-day simple moving average just kind of confirms the bull move we already know we're in.

If someone were holding a gun to my head, I suppose I'd say that I suspect the VIX is at or close to the low for the expiration cycle. But I don't believe that necessarily means the market is at or near the top for the cycle.

By Adam Warner of DailyOptionsReport.com

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