Financial Bottom, But Where's the VIX Fear?

Last Tuesday I noted the record-breaking volume in the the SPDR financial sector ETF (XLF), as significant enough to mark a short-term bottom in the entire market's slow drift to new 2 year lows. It wasn't the dramatic sell-off we all might have been looking for, but you can't argue with 469 million shares in the XLF when the last record was set only days before at 300 million. And my confirmation trade was the SPY trading over 500 million shares. All it took for last Wednesday's powder-keg rally was someone to light the fuse. Wells Fargo's (WFC) strong numbers and the SEC's sheriff going after the shorts did the job.

But, you know what we didn't get? We didn't get a dramatic spike on the VIX, the volatility index on S&P 500 (SPX) index options. I kind of suspected that we might not get the explosion in volatility to the mid-30's after talking to Bryan Perry of ChangeWave Tactical Trader two weeks ago. He thought we might not see the VIX spike to previous sell-off levels like we saw on the last 3 tradeable bottoms (Aug 07, Jan and March) because it was too easy and everyone was expecting it. Granted, the VIX spiked a little up through 30, but it definitely wasn't what the market had trained us to look for in terms of fear-driven options trading.

Bryan's call, as great as it was, still didn't explain things though. What made the difference? The only thing I could think of was that we were trying to use an indicator that measured one very specific thing, and that "very specific thing" wasn't cooperating as it typically did because it wasn't as much in play in this drama. The SPX options that the VIX uses for its calculation were not the primary players in last week's volume and volatility explosions. It was all about the financials. With that signal, on Tuesday I moved money into the S&P 500, via some index mutual funds, to capitalize on a run back to the 1,325-1,340 area. To confirm my thesis, I went to one of my favorite equity options pros.

Jud Pyle, Chief Investment Strategist for ONN.tv, believes that we didn't get that spike in the VIX because investors concentrated their buying of equity insurance and protection in the financial stocks and options themselves, and not directly in the SPX (S&P 500) options from which the VIX is derived. This was also evident in technology and energy stocks, which comprise almost 35% of the SPX, and which did not experience any comparable measure of volatility increase versus the financial sector.

Pyle said the normal "correlation trade" between stocks in the SPX and the VIX is always prevelant, but notes that the "astronomical premiums" in the options of financial stocks stole the show last Tuesday from the VIX. Investors were climbing over each other to buy protection in Fannie Mae (FNM), Freddie Mac (FRE), WFC, SunTrust (STI), Bank of America (BAC), and Zions Bank (ZION). "This shift kept a lid on the VIX," said Pyle. As of lunchtime Monday, the VIX was trading below 24.

Comments

[mavericks:]

This may be a little off color, but does anyone know exactly how the heavily traded (shorted) ETF's such as the QQQQ, SPY and the XLF contribute to the downward trend? Since these 3 ETF's are typically in the top 5 volume leaders and they are being heavily utilized to short and hedge by institutional and individual investors alike, I'm wondering exactly how they work. i.e. I know the ultra short funds do NOT actually short the component stocks but use futures and short swaps. So when you short say, 500,000 shares of the XLF, does anybody know if the fund goes out and actually shorts the component stocks or are they also using futures and options? Since they're not doubling the direction of the components, I'm wondering if they even need to use derivatives. My guess is a few times during the trading day, the fund offsets the buys and sells of the fund and then goes out and buys or sells the component stocks (not shorting) to adjust. i.e. they don't care if someone is shorting or just selling their long position, they're just trying to keep balance within the fund since its easy to keep track of the 'value' of the fund on a real time basis, but it seems to be harder to keep track of the buys, sells and shorts. Does anybody know?

2008 Jul 23 09:24 AM