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The VIX is abnormally low, i.e., below 14%. The graph below shows the VIX by trading day for the calendar years 2008 to 2013. The average and closing low during 2012 was 17.8% and 13.5% respectively. This compares to 24.1% and 14.6% for 2011. By viewing the graph below, what are the chances of the VIX remaining that low throughout the next couple of months?

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Now that the fiscal cliff issue is off the agenda, the Eurozone mess is most likely to resurface. As Angela Merkel put it in her new year speech: "The crisis is far from over." Some of the CDS spreads (proxy for sovereign risk) have been slowly rising; a clear indication that the Euro crisis is, well, far from over.

(click to enlarge)Financial risk monitor

Risk seeking behavior is very high, while economic surprises have been positive and rising for many months but have now stopped rising. The graph below compares the Citigroup Macro Index as a proxy for risk seeking behavior with the Citigroup Economic Surprise Index for the G10 that measures whether strategists and economists are surprised positive or negative by economic announcements. These two indices often move in tandem. At the moment, the rise in the surprise index has stalled whereas the macro risk index has reversed.

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There is a inverse relationship between the VIX, often referred to as a fear gauge, and the S&P 500 index. The latter typically falls while the VIX rises and vice versa. The graph below depicts this relationship with the VIX on the vertical axis and the SPX on the horizontal axis. The oval encircles all SPX/VIX combinations during 2011 while the rectangle shows all combinations during 2012 and 2013. Currently the SPX/VIX combination is in the lower right hand corner.

(click to enlarge)VIX vs SPX

We do not know what will cause the risk to rise or markets to fall. One does not need to. The fact that this combination is at an extreme suggests an asymmetric trade. Given the world we live in chances are much higher that we will be moving towards the upper left hand corner than there is probability to remain in the lower right hand corner for an extended period of time.

Investors wanting to hedge existing stock portfolios have various options at their disposal, i.e., selling index futures, selling index ETFs, buying short ETFs, etc. These are linear hedging instruments which means losses in the stock market are offset by profits in the hedging instrument in a more or less linear fashion.

Non-linear hedging instruments, namely stock and index options as well as instruments on the VIX, are quite different. Options allow the investor to introduce an asymmetry to his equity portfolio. When implied volatility is low, here measured by the VIX, the cash outlay for options is low. This essentially means there is a lot of potential bang for one's buck. If a disturbing event occurs, the profits will be larger when the investor spent less for the optionality.

There are also ETFs that should benefit from a rise in the VIX, for example VXX, UVXY, or TVIX. These ETFs are more suitable for short-term investments, i.e., days or weeks rather than months or years. The management of many of VIX products entail costs that results in an element of price decay of the product in the case of the VIX not spiking, i.e., losses during "periods of moderation."

Source: VIX About To Rise

Additional disclosure: IR&M is a research boutique specializing in investment matters related to risk management and absolute returns.