starspacer said:
Is anyone out there somewhat unnerved by the low VIX number? At 11.45, the reading is lower than at any time I can remember, and suggests an extraordinary amount of complacency.
I've scanned sources on whether the VIX is correlated to the SPX and from my limited info, there seems to be an inverse relationship (low VIX, high probability of forthcoming correction). For example, in October 04, the VIX was 13 when the S & P was 1140. A fortnight later, the S & P had fallen to 1100, whilst the VIX had risen to 17.
Anyone have any thoughts on this, or is it just another meaningless correlation?
Almost every volatility analyst . . . knows that when $VIX spikes up to a peak during a period of severely bearish action, then a "buy" signal is at hand. If you consider how this comes about, you will see that it has a contrarian basis. The spike peak in $VIX is caused by panicky "put" buyers paying up for protection and--once they have purchased that protection at top dollar--the market turns and rises in true contrarian fashion.
The fact that everyone agrees on the contrarian interpretation of a $VIX "buy" signal does not mean that they agree on any other $VIX interpretations. Specifically, what does a low $VIX mean? Those who only look back three years or so will tell you that a low $VIX precedes a declining market. That is not true when one considers a longer history (even assuming one knows what "low" is). Other, more astute $VIX analysts will tell you that when $VIX bottoms out and begins to rise, then the "sell" signal should be triggered. While this is a better interpretation than the previous one, it's still not correct.
What is true is that a bottom on the $VIX chart precedes a market explosion. If you think of this as a contrarian, you will see that it must be true. What does a low $VIX mean? It means that sellers of options are aggressive, that buyers of options are timid and therefore options are "cheap." In fact, these option traders don't expect the market to do much in the forthcoming days or weeks--that's why they let the air out of the options, making $VIX very low.
A contrarian knows what happens when a consensus is reached: the opposite! Well, what is the opposite of "...don't expect the market to do much?" It's a market explosion, of course. And the fact is that market explosions can occur in either direction. In the last few years, since we've been in a bear market, those explosions have come on the downside. But back in the 1990s, during the bull market, such explosions often came on the upside.
Therefore, to say that a low $VIX is bearish is wrong. Understanding that will separate you from most of the $VIX pretender-analysts out there.
Excerpted from the June 2003 issue of The Option Strategist.
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