Here’s something you don’t see every day. This is an intraday chart of the VIX (NYSEARCA:VXX
) last Thursday.
The panic seems almost surreal. I don’t pay attention to the VIX every day, but even when it rises, it will tend to oscillate as it does. Or you’ll see a spike at various points during the day, most likely near the open or close.
But on Thursday the VIX just kept rising … and rising … and rising. Even I felt a near palpable panic as the temperature climbed until whatever fever the market had broke around 3pm.
But what’s also interesting is that another volatility index, the VXV is also on the rise – with a more sustained increase than the VIX over the past several days. While the VIX measures the implied volatility of S&P 500 (NYSEARCA:SPY) index options on a one-month basis, the VXV reflects the same type expected volatility for the next three months.
This chart shows ratio of the VXV to the VIX over the past 7 months. Usually the VIX is lower than the VXV, but occasionally the ratio rises above 1.0, then falls back below that level as markets seem to calm down.
(Click charts to expand)
Click to enlarge
This assumes, of course, that the market expects only a "garden-variety" disaster. If the world financial system comes to an abrupt halt again, well all bets are off – although I will note that in late 2008, the VIX peaked above 80 while the VXV peaked near 70 (and that was several weeks later)
The reason the VIX should be lower than the VXV is simple. If the VIX and VXV represent the expectation that “something ” will happen to the stock market, perhaps a severe correction, when is that likely to occur? Is it more likely to occur in the next 30 days or the next 90 days?
All other things being equal, you’d say over the next 90 days, if only because there’s more time for your prediction to come true. When traders are willing to pay more for the shorter-term options, that indicates an awful lot of fear. Or to look at it another way, if you’re willing to pay more for a one-month fire insurance policy than a three-month policy just to get some insurance in place, it probably seems as if smoke is in the air.
Just as a comparison, this is what the VIX/VXV ratio looked like in early 2010. That elevated level in the ratio in May corresponded to the “flash crash” that month.
Click to enlarge
Note that just because the VIX/VXV ratio goes down doesn’t mean it’s sounding an all-clear signal for buying stocks. The market can continue to be range-bound or sink further. It just means panic is easing and the market has “accepted” whatever level it needs to get to.
If this ratio does soar past 1.0, you might consider selling shorter-dated options against longer-dated options. It’s no guarantee of a profit, but it can at least give you an edge from a volatility standpoint on a view that the relationship will normalize again.
Which it will. Because if it doesn’t, we have more to worry about than a mere volatility ratio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.