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VIX: How Low Can We Go?

|Includes: iPath S&P 500 VIX Short-Term Futures ETN (VXX), VXZ, VXZ

There is a great debate raging in the markets right now over the stubborn persistence of the volatility index (VIX) remaining over 40%. Is it still too risky to go back into the market? Are we going to new lows? Is the next big move an updraft or a downdraft? Part of the confusion springs from a misunderstanding of what the VIX is. It is just a mathematical guess about how big the next move in the market will be.  A 40% VIX implies that one out of three days will see a 2.25% palpitation, and once a month we will suffer a 4.5% gyration. You can have the market drop 10%, rise 11.1%, remaining unchanged, but still generate a tremendously high VIX. The equation doesn’t care what the direction is. VIX unfairly picked up a bearish connotation because of the panicked rush by long side only investors to buy downside protection in falling markets, driving put implied volatilities through the roof. This is why investors associate a high VIX with falling markets. In the end, this debate can only be resolved in one way, and that is to the downside. Smart hedge funds are now shorting out of the money calls on VIX. VIX will crash when markets go to sleep, as they inevitably will. Be careful what you wish for. Traders don’t pull down million dollar salaries playing “Solitaire” on their computers.