The VIX Ready to Move Higher!

The VIX and the Glass Half-Full Effect!

by Ian Harvey

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September 26, 2012

Introduction

Stocks took a breather last week after spending the first half of the month sprinting to new multi-year highs. While technology watchers had Apple Inc. (NASDAQ:AAPL - 700.09) to buzz about (iPhone 5, $700, iOS 6), others concerned themselves with a gloomy outlook from FedEx Corporation (NYSE: FDX - 84.39) and continued global unrest. The result was a modestly lower weekly finish for the major market averages.

But let's not forget about those multi-year highs. It is always best to continue to view the market positioning as the proverbial glass as half full -- especially with all those short positions still hanging around – and the environment could be ripe for a move higher in the CBOE Market Volatility Index (VIX - 13.98).

Reasons Why the CBOE Market Volatility Index May be Headed Higher!

"...the sentiment backdrop remains one in which there is plenty of demand via short-covering and/or asset reallocations (think of the massive inflows into bonds that could be directed back to stocks) to provide fuel for the current rally, or at least provide support on dips. It is an environment in which the shorts are fighting the tape and fighting the Fed."
-The Shorts Will Help The Stock Market Rally To Continue, September 17, 2012

"...trading-desk chatter is focusing on buying defensive options when volatility is low before major events like earnings, and the election, potentially scaring investors into buying portfolio hedges. After slumping to multiyear lows following the Fed's action, the VIX has seen a sudden uptick; the VIX call buying shows that investor confidence is not nearly as sanguine as widely described."
- Barron's, September 20, 2012

“50%’ dominated the trading perspective headlines during the course of last week and most of these headlines related to the popular CBOE Market Volatility Index (VIX - 13.98), and its ticker.

From late March through July was the tendency for the CBOE Market Volatility Index to peak at levels 50% above the calendar-year low, which ranged between 20.49 and 21.39, depending on whether you are using intraday (March 16 - 13.66) or closing (March 26 - 13.26) lows. After the CBOE Market Volatility Index "broke out" above this area in May, a retest of this range occurred before an eventual run to the 27.50 area, roughly double the calendar-year low.

In a replay of August expiration Friday, the CBOE Market Volatility Index is again trading in the area that represents "50%" of the calendar-year high, or "half high." As you can see on the chart below, the CBOE Market Volatility Index advanced sharply from this level ahead of key events such as the expiration of the Facebook Inc. (NASDAQ: FB - 22.86) lock-up period, various key meetings in Europe, and the central bank meeting in Jackson Hole, Wyoming.

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One might think the Standard & Poor's 500 Index (SPX - 1,460.15) declined sharply over this period, but remarkably, it remained in a range between 1,400 and 1,420. The behavior of the VIX was akin to a typical implied-volatility surge in a company's options ahead of a potentially volatile event, such as earnings.

The following may be catalysts for the VIX to lift back into the 17-18 area:

1. September expiration is behind us, including VIX options that expired Wednesday last week. The implication is that hedged positions that have expired could be replaced, as index protection is perceived as cheap by many market watchers.

2. There is still an extremely cautious mentality among traders and investors -- witness the record call open interest on VIX options just before September options expired on Wednesday.

3. The CBOE Market Volatility Index is trading 50% below its calendar-year high, a level that was supportive last month at this point in the expiration cycle.

4. Earnings season is around the corner, and elections are just down the street.

An Optimistic Sentiment Perspective

One sign that points to a potential upset in the market (from a sentiment perspective) is growing optimism among investment managers, according to the most recent National Association of Active Investment Managers (NAAIM) survey. Another is the growing optimism among equity option buyers, who are now buying two calls for every put. This activity is similar to what we witnessed prior to the market correction that began in April.

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Stock Market Pullback

If a pullback does materialize, expect it to be shallow, given the relatively large outstanding short position in the market that has been discussed several times in the past several weeks in similar articles. It is possible that the shorts may be looking to cover after being caught off-guard with respect to recent central bank actions around the world.

Also, with VIX call open interest at its highest level ever following a VIX expiration, it is evident that institutional players are bracing for the possibility of negative outcomes regarding the expected decline in earnings growth and the uncertainty regarding elections and the ”fiscal cliff”.

If buyers retreat -- and a cautious mentality prevails like we saw leading up to the August/September events -- we could be in for another range-bound trading environment or even a pullback to support. Keep an eye on the 1,415-1,420 area on the SPX, site of the April high and the index's 40-day moving average, which contained pullbacks in July.

That said, 1,500 is still only a stone's throw away, before a potential run to all-time highs in the 1,550 area when (and if) the short-covering we expect to eventually occur is unleashed.


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Other Important Articles Relating to the Week Ahead

1. The Past Week Stock Market Results – September 24, 2012

2. The Week Ahead in the Stock Market – September 24, 2012

3. The Economy and Earnings in the Week Ahead – September 24, 2012

4. The Major ETFs in the Week Ahead – September 24, 2012

5. Quantitative Easing and Its Effect on the Stock Market - Indicator of the Week - September 24, 2012


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