Reflections on Current Volatility

Includes: VXX, VXZ
by: Bill Luby

Being a West Coast guy, I often find myself three hours behind the rest of the blogging world when I stumble out of bed. Once or twice a year, I manage to sleep through the open and generally spend the rest of the day playing catch-up, as was the case yesterday. Now that I am mostly coherent and have digested the bulk of the news and market movements for the first three hours of yesterday’s session, let me offer some comments.

While stocks are enjoying an Intel (NASDAQ:INTC) inside jump, the VIX is up a shade as I type this, seemingly intent on staying above the 25.00 level. On the other hand, three of other major market index volatility measures I follow (VXN, RVX and VXD) are all down in the 5-7% range for the day. The outlier among the secondary volatility indices is VXO, the volatility index for the S&P 100 index (OEX), which is only down about 2% on the day. (I am not sure exactly how to parse this information, but with the meat of second quarter earnings season just around the corner and options expiration only two days away, I would not be surprised to learn that portfolio managers are looking to lock in some profits and add some additional downside protection.)

In the last day or two, a number of other bloggers have commented up on the volatility premium issue. In VIX Predicting the Future…and It’s Cloudy, Jason Goepfert of Sentiment’s Edge has an excellent chart of the premium of the front-month VIX futures to the spot VIX index and points out that a high premium has lately been bearish for stocks. Adam Warner of Daily Options Report picks up the premium theme in While We Were Churning…… as does the Decline and Fall of Western Civilization blog in Volatility Curve Warning Again.

The premise is exactly the same reasoning as is behind the VIX:VXV ratio and the VXX:VXZ ratio: when short-term volatility measures become substantially out of line with longer-term volatility measures, the divergence is most likely to be resolved by the short-term measure ‘correcting’ in the direction of the longer-term measure. With the VIX:VXV ratio recently hovering around 0.85, this means a VIX spike is more likely to take the ratio back toward equilibrium than a substantial drop in the VXV index. By the same token, VXX and VXZ are more likely to converge as a result of a jump in VXX than a decline in VXZ. Of course, the numerator and denominator can always converge at the same rate, but that type of resolution seems to be relatively rare.

For those who may be interested, my various estimates of fair value for the VIX are largely in the range of about 28-29 at the moment, suggesting that short-term volatility is due for a bounce soon.

As a reminder, anyone wishing to speculate on the VIX using options and futures should note that VIX options expire next Wednesday (July 22), with the last day of trading on Tuesday.