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Ross Aldridge Las Vegas Nevada And RAC Consultants Review The Triple Spike In The VIX Last Week!

|Includes: C, Goldman Sachs Group Inc. (GS)

Ross Aldridge Las Vegas Las Vegas Nevada and RAC Consultants reviewed the triple spike chart pattern in the VIX last week. First, this is not 2008 where the VIX obtained a record of over 89: however, a similar triple spike pattern was experienced 90 days prior to the jump from 30 to 60 in a matter of days. We are not in the same economic conditions but political uncertainty is a cause for concern. After reviewing the individual sector VIX we have ascertained that the Financial Sector is the most bendable while being considered the safest haven or safe harbor if we see an additional triple spike with heavy sell volume.

What is the VIX and what is its history?

VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30 day period.

The idea of a volatility index, and financial instruments based on such an index, was first developed and described by Prof. Menachem Brenner and Prof. Dan Galai in 1986. Professors Brenner and Galai published their research in the academic article "New Financial Instruments for Hedging Changes in Volatility," which appeared in the July/August 1989 issue of Financial Analysts Journal.

In a subsequent paper, Professors Brenner and Galai proposed a formula to compute the volatility index.

Professors Brenner and Galai wrote "Our volatility index, to be named Sigma Index, would be updated frequently and used as the underlying asset for futures and options... A volatility index would play the same role as the market index play for options and futures on the index."

In 1992, the CBOE retained Prof. Robert Whaley to create a tradable stock market volatility index based on index option prices. In a January 1993 news conference, Prof. Whaley reported his findings. Subsequently, the CBOE has computed VIX on a real-time basis. Based on the history of index option prices, Prof. Whaley computed daily VIX levels in a data series commencing January 1986, available on the CBOE website. Prof. Whaley's research for the CBOE appeared in the Journal of Derivatives.

The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the upcoming 30-day period, which is then annualized. "VIX" is a registered trademark of the CBOE.[4]

Specifications

The VIX is calculated and disseminated in real-time by the Chicago Board Options Exchange. Theoretically it is a weighted blend of prices for a range of options on the S&P 500 index. On March 26, 2004, the first-ever trading in futures on the VIX began on CBOE Futures Exchange (CFE). As of February 24, 2006, it became possible to trade VIX options contracts. Several exchange-traded funds seek to track its performance. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations.[5] The goal is to estimate the implied volatility of the S&P 500 index over the next 30 days.

The VIX is calculated as the square root of the par variance swap rate for a 30 day term[clarify] initiated today. Note that the VIX is the volatility of a variance swap and not that of a volatility swap (volatility being the square root of variance, or standard deviation). A variance swap can be perfectly statically replicated through vanilla puts and calls whereas a volatility swap requires dynamic hedging. The VIX is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days. The VIX is quoted as an annualized standard deviation.

The VIX has replaced the older VXO as the preferred volatility index used by the media. VXO was a measure of implied volatility calculated using 30-day S&P 100 index at-the-money options.

Interpretation

The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period. That is, index options are priced with the assumption of a 68% likelihood (one standard deviation) that the magnitude of the change in the S&P 500 in 30-days will be less than 4.33% (up or down).

The price of call and put options can be used to calculate implied volatility, because volatility is one of the factors used to calculate the value of these options. Higher (or lower) volatility of the underlying security makes an option more (or less) valuable, because there is a greater (or smaller) probability that the option will expire in the money (i.e., with a market value above zero). Thus, a higher option price implies greater volatility, other things being equal.

Even though the VIX is quoted as a percentage rather than a dollar amount there are a number of VIX-based derivative instruments in existence, including:

  • VIX futures contracts, which began trading in 2004
  • exchange-listed VIX options, which began trading in February 2006.
  • VIX futures based exchange-traded notes and exchange-traded funds, such as:
    • S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ) launched by Barclays iPath in February 2009.
    • S&P 500 VIX ETF (LSE: VIXS) launched by Source UK Services in June 2010.
    • VIX Short-Term Futures ETF (NYSE: VIXY) and VIX Mid-Term Futures ETF (NYSE: VIXM) launched by ProShares in January 2011.

Similar indices for bonds include the MOVE, LBPX indices.

Although the VIX is often called the "fear index", a high VIX is not necessarily bearish for stocks.[7] Instead, the VIX is a measure of market perceived volatility in either direction, including to the upside. In practical terms, when investors anticipate large upside volatility, they are unwilling to sell upside call stock options unless they receive a large premium. Option buyers will be willing to pay such high premiums only if similarly anticipating a large upside move. The resulting aggregate of increases in upside stock option call prices raises the VIX just as does the aggregate growth in downside stock put option premiums that occurs when option buyers and sellers anticipate a likely sharp move to the downside. When the market is believed as likely to soar as to plummet, writing any option that will cost the writer in the event of a sudden large move in either direction may look equally risky.

Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. Only when investors perceive neither significant downside risk nor significant upside potential will the VIX be low.

The Black Scholes formula uses a model of stock price dynamics to estimate how an option's value depends on the volatility of the underlying assets.

Here is a timeline of some key events in the history of the VIX Index:

Between 1990 and October 2008, the average value of VIX was 19.04.

In 2004 and 2006, VIX Futures and VIX Options, respectively, were named Most Innovative Index Product at the Super Bowl of Indexing Conference.

Summary: Ross Aldridge Las Vegas Nevada and RAC Consultants concluded the following conclusion.

In conclusion, history has a way of repeating itself and we are approaching the cross roads of another triple spike pattern within the next 90 days. While the 2nd Quarter of 2014 will be a volatile time we anticipate the market to close up 10% of our 2013 prediction.

We would advise to hedge with SKF.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SKF over the next 72 hours.