Are VIX Futures Signaling End of Year Slump?

In a perfect world the value of standardized futures on deliverable assets is determined via arbitrage argument, or FP = SP*(1+RF)^t.

But a unique opportunity arises in the pricing of futures that can not be arbitraged. In this scenario there is only one force setting the price: unbiased expectation of the future price of the asset. This is the case in VIX futures (CBOE Volatility Index Futures).

Looking at the VIX Futures, it is clear that market participants are anticipating a VIX rally starting in the next few weeks and continuing through 2008.

It is important to note, the VIX moves inversely to the S&P 500 and even more so when the S&P 500 declines. According to the CBOE:

From 1990 to 2004, daily returns of VIX and the S&P 500 had a correlation of .56 for down S&P 500 moves and .40 for up moves. Over the same period, a 1% decrease of the S&P 500 was accompanied by a 4.26% average increase in VIX while a 1% increase of the S&P 500 was accompanied by a 2.30% decrease in VIX.

So clearly VIX Futures traders are anticipating a sharp rally in the VIX, which would likely be correlated with a 5%+ decline in the S&P. Add this to why I am not buying the market’s recent rally.

Stock position: None.

Comments

[abbottmd:]

But if the VIX participants are EXPECTING this decline in S&P, isn't that a contrarian indicator that we might not get it?

2008 Aug 24 01:28 PM

[Capitalist Cow:]

VIX participants aren’t necessarily expecting a decline in the S&P, just an increase in the extrinsic value of SPX options. The VIX could spike and the market could go higher. In the late 1990’s the VIX was over 40 while the market was pushing higher. VIX traders are just expecting an increase in Volatility.

A pickup in the VIX is usually correlated with a decline in the S&P. But it could just be the market expecting: Fannie or Freddie failure, Lehman failing, or an encounter with Russia.

Abbottmd, some indicators work others don't. Nothing is certain.

2008 Aug 24 03:36 PM

[whidbey:]

Overall the post is likely correct, but one must look to other indicators as well. The most negative that can be seen right now is damage to the USA financial markets, and that expected through the remainder of the year. I think being short equities and long PMs is the trade for the fall.

2008 Aug 24 05:49 PM

[300mph:]

I would gladly take a 5% decline in the S&P 500, if that's all it goes gown.

2008 Aug 25 02:29 PM