On Aug. 17, 2012, the closing value of VIX was 13.45, a level not seen since June 19, 2007, when the closing value of VIX was 12.85. The recent lows in VIX have many market naysayers talking: "Such a low VIX level shows investor complacency and is a reliable signal of market tops." The fact that SPY prices have hit new highs since May 2008 is another thing that market naysayers have continuously discredited.
I must admit that with all the problems unresolved in Europe, concerns over Chinese economic slowdown, and possible falling off of the fiscal cliff in the U.S., it is easy to sympathize with their arguments that this equity market has been manipulated upward by central banks and that it is set for a free fall. Yet, looking at the markets and VIX objectively, I have to take a different point of view. Recent earnings announcements from Cisco gave support to what I have been thinking:
- The global economy is not as weak as feared.
- U.S. multinational companies are enjoying the benefits of global markets growth through their global reach.
- The S&P 500 Index has become more and more a barometer of the global economy.
Logically, higher economic growth supports higher corporate profits, which then supports higher stock prices. Furthermore, rising stock prices correlates strongly with low or declining volatility.
The following graph plots IMF's annual global GDP growth figures and projections, along with the inverse of long-term, monthly VIX levels. Visually and logically, the graph makes sense. Perhaps prospects for higher global GDP growth from 2013 are the driving force behind rising equity market prices and falling VIX levels. If the IMF global GDP projections end up close to reality, VIX could easily move within historically lower ranges -- in other words, between 10 and 20 as it did from 2003-06.
Click to enlarge images.
The chart below shows historically VIX moving from a period of low volatility equilibrium to a period of high volatility equilibrium, and back and forth. VIX falling to lower lows recently should be taken as a signal of an equilibrium shift in VIX levels happening before our eyes, and not as a signal of a market top.
If this is true, then I must consider adjusting the median VIX levels in the models I use to calculate the "fair value" of VIX. Perhaps median values, represented by blue/cyan in the chart below, or something similar would be more appropriate to calculating expected VIX levels going forward, rather than using the long-term median VIX levels in black/grey.
One thing for certain is that VIX futures prices and VIX futures term-structure are still showing a steep contango. One of the best bets to make throughout the past 11 months was to short front-month VIX futures as the steep premium of VIX futures prices moved to zero at expiration settlement. I believe that shorting VIX futures would still be a good bet going forward, especially in consideration of the possibility that an equilibrium shift to low levels is now taking place
What is the point of looking long term when the trading strategies executed are very short term? Sometimes it helps to get a satellite view of what is going on with volatility. Whenever VIX spikes, I would continuously be looking for opportunities to short VIX futures deltas by 1) shorting VIX futures, 2) using VIX or VXX options, 3) shorting VXX, 4) going long XIV, 5) shorting VXZ, or 6) going long ZIV as long as the contango remains steep (ZIV is highly illiquid -- therefore I would not suggest it as a trading vehicle yet).
Steven Lee is a Senior Options Instructor for Trading Advantage, LLC.