VIX Premiums High Cost – A Deterrent to Potential Buyers!!

The VIX being driven to a substantial premium relative to SPX historical volatility!

Wall Street: Optimism is on the Rise, Even as Stocks Approach Formidable Resistance!


A pullback is likely at this point, as the major equity indexes finished last week just below significant resistance levels. The question remains as to whether the recent crop of bullish headlines is a potential indicator -- or just a natural reaction to the market's impressive rally.

In the last couple of weeks it has become apparent that there has been a growing possibility of a pause in the impressive stock market advance, as some institutional players were showing signs of initiating short positions once again, following a period in which the equity market enjoyed a bid from both short-covering activity and underweight institutions deploying cash into the market.

Since Friday, Feb. 3, when all three major market indexes finished the session comfortably in the black, and the Nasdaq Composite (COMP) scored its best settlement since December 2000, the market has done very little. A negative turn in the Greek debt saga last Friday, Feb. 10 sent stocks sharply lower, erasing a choppy grind higher throughout most of last week. The only encouraging technical note is that the SPDR S&P 500 ETF Trust (SPY - 134.36) never retreated beneath the previous Friday's post-gap lows or its lows earlier in the week.

SPY-30 minute chart

It has become quite evident that optimism has been creeping into the market, right as the S&P 500 Index (SPX - 1,342.64) and the S&P 400 MidCap Index (MID - 964.49) approached their 2011 resistance levels in the 1,350 area and the 1,000 millennium mark, respectively. With key equity indexes lingering near resistance, these bullish headlines suggest we could be ripe for a pullback -- or, at the very least, continued choppiness in the days ahead:-

• "S&P 500 Set To Confirm Trend Change to Bullish" -- Dow Jones Newswires, Feb. 9

• "Fink: Investors Should Be 100% in Equities" -- Bloomberg, Feb. 8

• "Dr. Doom Thinks Rally Has Legs, At Least for Now" --, Feb. 7

In addition to the Feb. 9 headline suggesting a bullish technical backdrop, there has been technical research suggesting the CBOE Market Volatility Index’s (VIX - 20.79) recent breakout has bullish implications.

Therefore, the fact is that the market may be vulnerable to giving back some of its gains in the near term, as optimism is apparent as the SPX and MID approach key resistance areas. A short-term pullback would be healthy, and would not jeopardize the overall bullish stance on equities for the intermediate and long term.

However, this does not mean that a retreat will definitely occur in the short term. After all, the positive sentiment isn't exactly misplaced, with the SPX up about 22% in a four-month period.

The good news for bulls is that in the event of a pullback, they would not expect a decline to be exacerbated by panic selling, since those that have recently accumulated stocks have purchased index or exchange-traded fund (ETF) puts, or VIX calls, as insurance against a correction. This was not the case around this time last year, when un-hedged buyers drove equities higher into mid-February, before negative European headlines surprised investors, resulting in a 7% correction in a month's period. Moreover, institutions at present do not have the exposure to equities that they did at the beginning of 2011, which suggests fresh cash on the sidelines that could mute a decline.

Finally, the "VIX Premium" indicator is again at the forefront, which is a measure of the VIX relative to the SPX's actual, historical volatility. Given the steady demand for index and ETF put options that have accompanied the rally, put premiums have risen considerably relative to call premiums, driving the VIX to a substantial premium relative to SPX historical volatility.

For example, the VIX closed at 20.79 on Friday, or 146% above the SPX's current historical volatility of 8.44. As you can see on the chart below, the current VIX premium is relatively high. Therefore, a risk to bulls is that hedged players find put premiums too expensive, and thus sharply reduce their equity accumulation due to the expensive portfolio insurance. As you can see on the chart below, when the VIX is at a discount or is trading at a small premium to historical volatility -- implying cheap portfolio insurance -- major short-term buying opportunities have occurred during the past several months.

vix/spx premium comparisons

With portfolio insurance relatively expensive -- and thus unattractive for some hedge fund managers looking to put cash to work -- and the SPX and MID trading just below former resistance, the near-term price action may not be as rosy as the past several weeks. But pullbacks should continue to be viewed as buying opportunities, as considerable cash remains on the sidelines.

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