IS THE VIX A SIGNAL OF FURTHER SELLING TO COME?
Courtesy of The Pragmatic Capitalist
There is a lot of chatter regarding the recent action in the VIX. The index is by no means a holy grail, but a lot of smart money tends to hang out in the options markets so it’s not an indicator that you want to shun. Anyhow, the VIX terms structure is in a steep contango which is implying a summer slow-down in volatility followed by a massive ramp in October. FT Alphaville wonders if the smart money isn’t preparing for something “scary” in the markets this fall. But MKM Partners is a bit more optimistic about the action in the VIX (via Daily Options Report):
“Although spot VIX has declined sharply over the last couple of weeks to close at 24.56 yesterday, its low since mid-June, longer- dated maturities have barely budged. This upward-sloping volatility term structure is approaching its steepest level in recent years (measured between spot VIX and the six- month future), likely reflecting imbedded skepticism in the aftermath of the May 20 volatility spike.
This condition is typically not sustainable, and we think it must be resolved either with the short end of the curve snapping back toward recent elevated levels or the long end drifting lower. Given our view that spot VIX will remain downward-trending over the intermediate term, we expect the latter scenario to play out. This suggests that the term structure of VIX will flatten while the curve will gradually shift lower toward its position earlier in 2010.
From a volatility trading perspective, this dynamic can be exploited in single stocks via long gamma, short vega strategies (i.e., buying short maturities to sell long maturities delta-neutral). Directional investors who are long stocks with steep term structures and who are bullish over the short term could similarly buy near out-of-the-money calls in one- or two-month tenor while selling further out-of-the money calls around six-month tenor. This creates a leveraged overwrite that provides short-term upside exposure in parallel with the long stock, while committing to selling those shares at a higher level.”
I would tend to agree with MKM. In my opinion there is no “smart money” that knows what is going to occur in October. These markets have had a hard enough time discounting what will happen tomorrow let alone in 3 months. The near-term action, however, is a bit more interesting as the VIX is beginning to find some support despite a very bullish move in equities. A VIX over 24 is by no means low and it now sitting at the exact levels where we were before the market last took a dip. To me, this is the more important story. The smart money is hedging themselves after an incredible 9% move in equities in just over a week. This appears prudent to me….
