Weekly Volatility Tracker: Hiccup or Hangover?

Volatility Tracker for the week of November 1, 2009 (.pdf)

Equity markets have been drunk on the wine of federal stimulus for most of this year. While the increased volatility in the latter half of last week could amount to a mere hiccup in the reflation rally, indicators suggest that more participants are concerned about an equity market “hangover” than at any time since the market bottom. The transition to a different market environment may have just occurred, and in the absence of any plausible catalysts, I’m not yet giving serious consideration to the possibility of a market crash, so the remaining likely regimes are a continued momentum-driven rally or the return of mean reversion.

I’ve introduced a new element on the Implied Correlation Index chart [see chart 10] – the dark blue line tracks the ratio of near- and longer-dated indexes (currently CBOE:ICJ and JCJ). The near term index, ICJ, expires in January 2010, while JCJ expires in January 2011. The ratio, therefore, tracks the extent to which short term expectations of increased equity correlations are being mirrored over the long term. That ratio spiked higher on Friday and could easily eclipse the high set just prior to the March bottom in equities. Likewise, the VIX Premium Ratio [see chart 8] hasn’t been this low since March 9th. Note the negatively skewed daily returns in the S&P 500 over the last three months [see chart 9]. The VIX futures term structure is now (finally) flat [see chart 7]. These indicators all register the heightened concern among market participants, and give weight to the view that the momentum-driven rally may be over.

Unless the market is gearing up to give back all of the gains of September or worse, it makes sense to be selling out of the money puts or put spreads here in equity index options.

1. Comment. Highlights items of note in the data below along with our short-term volatility bias and any trading theses. The Expected Daily Move table displays the de-annualized price and percentage change in each underlying asset as implied by its volatility index, within one standard deviation. The Forward Bias table displays my bias for the movement of the price and implied volatility of several assets for the coming week.

2. Weekly Change. Tracks the weekly percentage change in the assets listed and in their implied volatility indexes.

3. Implied Volatility Indexes. A one year chart of the implied volatility indexes for the S&P 500, gold, oil, and USD/EUR. Indexes for the Nasdaq 100 and Russell 2000 are omitted because of their tight correlation with VIX.

4. S&P 500 Price and BollingerBands. Tracks daily closing prices in SPX with an overlay of one and two standard deviation 50-day bands.

5. S&P 500 Implied and Realized Volatility. Tracks the 21-, 60-, and 90-day realized (or “historical”) volatility of the index and the21-day lagged CBOE Implied Volatility Index ("VIX"). Realized volatility is displayed as the annualized standard deviation of lognormal returns over the period specified, and may be thought of as a backward-looking measurement of price behavior. Implied volatility is the annualized standard deviation of returns implied by option prices, and may be thought of as a forward-looking measurement of expected price behavior.

6. S&P 500 Implied/Realized Volatility Ratio. Tracks the ratio of 21-day lagged implied volatility (IV) to 21-day realized volatility (RV). This ratio asks how well IV from one month ago predicted the RV over the next 21 trading days (roughly, 30 calendar days). When IV correctly anticipates RV over the period, the ratio will hover near 1; we regard the area near 0.9 –1.2 as normal, given the persistence of a volatility risk premium in equity market derivatives. A ratio less (greater) than 1 indicates that the price behavior of the underlying asset was more (less) volatile than anticipated.

7. Volatility Futures Term Structure. Tracks the Friday closing prices of the VIXFutures forthe two weeks prior, along with the spot levels for reference.

8. VIX Premium Ratio.Tracks the ratio of rolling three-month (VXV) to one-month (VIX) implied volatility. Periods in which one-month readings persist at an extreme premium or discount to three-month levels have tended to coincide with major market moves.

9.S&P 500 Daily Return Distribution (3 month). Histogram plotting the frequency of daily percentage returns over the prior 63 trading days.

10. Implied Correlation Index. Reflects the market-capitalization weighted average correlation of the 50 largest components of the S&P 500.

11. Gold Price and BollingerBands.Tracks daily closing prices in GLDwith an overlay of one and two standard deviation 50-day bands.

12. Gold Implied and Realized Volatility. Tracks the 21-, 60-, and 90-day realized (or “historical”) volatility of the ETFand the 21-day lagged CBOE Gold Volatility Index ("GVZ").

13. Gold Implied/Realized Volatility Ratio. See #6 above; given the novelty of the VIX-style gold volatility index (GVZ) and the characteristics of the underlying, we do not yet have a range we regard as normal.

14. Gold Daily Return Distribution (3 month). See #9 above.

15-18. Oil charts correspond to 11-14 above.