Pater Tenebrarum

About the Author Pater Tenebrarum

I'm an independent analyst and have been involved with financial markets for 31 years. I write economic and market analyses for independent research organizations and a European hedge fund consultancy. I'm the main author of the blog 'Acting Man', which presents articles on the markets and the economy, a mixture of commentary on current events as well as economic theory and history from an Austrian school of economics viewpoint.

VIX: A Look At Market Volatility

By Evil Speculator

Volatility over the Long Term

No matter if you are a hard nosed trader or a casual investor, every once in a while it’s advisable to detach yourself from the daily grind, sit back, grab a hot beverage, and parse through some long term charts. Although the don’t affect our daily entries here at Evil Speculator, they do give us a better view of what type of market we are navigating and thus how we may have to adjust our trading patterns.

2016-04-13_trainImage credit: Walt Disney Pictures

After all – context is everything. What may have worked very well in 2012 most likely hasn’t worked in the past year or so. When markets change traders have to change with them or they will find themselves on an extended losing streak.

1_VIXThe VIX vs. SPX since 2008 – click to enlarge.

I have been talking quite a bit about volatility as of late, the research of which has become a personal past time or even fascination of mine. So not surprisingly I will start our little journey with implied volatility which most commonly is expressed by the VIX. The first thing that really should be appreciated is the fact that we are experiencing more volatility of volatility. Yes, you read that correctly – actually what I should have said is that realized volatility (i.e. amplitude) of implied volatility (IV) is on the increase.

If you compare the past few years the only comparable years are 2010 into 2011. Starting in 2013, IV consistently dropped and then formed a very clean baseline throughout 2013 between 12 and 20. For the bulls that year was tantamount to manna from heaven. A smooth casual advance only interrupted by a few shallow medium term corrections.

Now if you compare that with 2014 then you are seeing the first big August scare which level the playing field for a pretty frustrating market phase all through 2015. What is interesting is that the big IV spike in 2015 was not exceeded by the one accompanying the very comparable correction early this year. To start with I find the timing of that one rather interesting, but it seems that market participants are now relying on the Fed to carry them through yet another year of appreciation in equities. Well, we shall see – let’s look at a few more charts.

Pricing of Near Term Risk Increases


I have been following the VIX:VXO chart which with interest over the past few years. We are comparing 30-day IV across the option chain (ITM and OTM) with that of only ATM and NTM. In other words we want to know the ratio between option pricing near or at the money in comparison with the average of the entire option chain. The reason we do that is to figure out if near term risk is perceived as being higher. If so, then we know that market makers who price risk are anticipating greater short term downside potential.

Once again I have highlighted the 2015 period up until today. And quite clearly something has changed here. The entire range seems to have taken a step down. There are only two ways how the entire ratio range could do that – either the VIX has risen significantly (well, somewhat but not that excessively) or the VXO has risen or at least risen more than the VIX.

3_VXO_VIX_divergenceVXO and VIX are diverging – click to enlarge.

In order to figure out what is what I decided to stack the two on top of each other. And I believe the lines I drew tell the story rather clearly. The VXO (in blue) has a steeper and higher base than the VIX. And that means short term at-the-money (ATM) and near-the-money risk is on the increase.

Quarterly vs. Monthly IV: Bigger Spikes

Now let us visit quarterly IV and compare it with monthly IV: The long spikes that run inverse to the S&P Cash show us bullish reversal points. They were quite a bit more shallow during 2012 and 2013 when the bulls pretty much were running things uncontested. There was a complete absence of any major volatility spikes throughout 2013 until the fall of 2014. The bulls tried to cling to their all time highs but in the end had to give it up in late 2015. No matter how high you fly, gravity in the end always takes care of business.

4_VIX_VXVThe VIX-VXV ratio – VXV describes three-month SPX IV – click to enlarge.

What is notable right now is that we actually painted another ratio spike down but it was completely ignored. But it is rather common that VIX:VXV spikes precede market corrections and don’t accompany them. Keep in mind that implied volatility describes sentiment and risk perception, not actual risk occurrence.

Below is  another way of looking at the same ratio –  I flipped it around and smoothed it out a little. And the 5-day SMA actually has us at pretty extended readings. So being long here apparently does represent a bit of downside risk. Once again take note of the signal accompanying the medium-sized correction in January of this year. What’s going on there?

5_VXV_VIXThe 5-day moving average of VXV-VIX (the above ratio inverted) – compared to the August correction, the January sell-off produced a much smaller decline in the ratio – but right now, it is at quite elevated readings – click to enlarge.

That’s easily figured out – placing the two indicators on top of each other shows us that the VIX rose quite a bit more than the VXV.

6_VXV_VIX_CorrelationVXV and VIX compared – click to enlarge.

One could argue that traders considered long term (quarterly) risk as more limited than short term (monthly) risk. Sure, that sounds plausible but why didn’t the same thing apply back in 2010 through 2013?

Most likely the 2008 crash was still fresher in people’s minds and apparently participants today are doubtful that we could see a repeat of that.


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