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The VIX
Higher Volatility on the Horizon



Pay attention to the VIX – interpret what it is telling you if you want to really up your game and obtain master “market feel” status!



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March 16, 2012

Volatility, at this period of market time is at an extremely low level -- the stock market rally has been quite resilient... upwards bound with low volume to higher prices.

As measured by the widely followed CBOE Market Volatility Index commonly known as the VIX , or the “fear gauge”, it recently put in a five year low.

Extremely low readings in the CBOE Market Volatility Index infers that investors have become very complacent with regard to risk. More to the point, these low readings usually coincide with short-term market tops.

The Challenge of Prediction and Future Management of Your Potfolio

It's important to note that volatility can remain low for extended periods of time, therefore, the challenge is to figure out when market volatility will once become an important factor in investors decision and profit-making!

By monitoring the CBOE Market Volatility Index it is obvious that it’s currently giving a huge clue that higher volatility may be coming back not only sooner, but with a greater magnitude than most investors think, which could be disastrous for the market rally that has been enjoyed for the last several months.

This is very important information in helping you manage your investment strategy and better protect your portfolio assets if you can identify it early.

The VIX at Present

The CBOE Market Volatility Index just hit a multi-year low, briefly dipping below 14.00 this past Tuesday. Wednesday it closed at 15.31 -- a level that is still very indicative of overly complacent investors.

CBOE Market Volatility Index (5 year daily chart)

VIX-031512



A simple explanation of the CBOE Market Volatility Index is that it measures implied volatility. Specifically, how expensive option premiums are on the S&P 500 index that are roughly 30 days from expiration.

High readings (above 30) usually infer elevated fear among investors who are bidding up the price of options (protection). The markets are more active with heavier volume and wider ranges.

Low readings (below 18) usually infer subdued levels of fear, and option prices tend to recede as investors become comfortable selling premium (generate income). The markets tend to behave in a more orderly fashion with lower share volume and tighter ranges like we’re seeing right now.

Market volatility tends to mean reverting. While the historical average of the CBOE Market Volatility Index is around 20, you can see from the five-year chart above that it can spike very high during times of heavy market stress, or can fall and stay subdued below its mean for months at a time.

“Mean Reversion” is a theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.

This theory has led to many investing strategies involving the purchase or sale of stocks or other securities whose recent performance has greatly differed from their historical averages. However, a change in returns could be a sign that the company no longer has the same prospects it once did, in which case it is less likely that mean reversion will occur. Percent returns and prices are not the only measures seen as mean reverting; interest rates or even the price-earnings ratio of a company can be subject to this phenomenon.

Therefore, it is common knowledge that the CBOE Market Volatility Index is low. As well as this, it is also obvious that the markets have been continuing their rally in a lock-step movement with a low reading in the CBOE Market Volatility Index. Trading has been orderly, with lower average volume and tighter intraday ranges.

The Future Direction of the VIX

It is inevitable that volatility will eventually shift at some point! At the very least revert to its mean average. More realistically, move much higher and spike sometime in the future during the next market crisis, whatever that may turn out to be.

However, low volatility can hang around for quite some time, generally much longer than the periods of high volatility.

As the VIX is an index, and does not trade as a security -- it’s simply a quantifiable perpetual mathematical calculation that measures implied volatility on S&P 500 index options – therefore, when looking at the CBOE Market Volatility Index, it’s a “spot price” that needs to be identified!.

And while it certainly gives a decent amount of information about the current volatility environment, analysis can be taken to the next level-- into master “market feel” territory!

Several years ago, VIX futures and VIX options on futures were introduced and became tradable products. And while you may have no desire to trade these products, a wealth of free information lies at your fingertips as a result.

By following the CBOE Market Volatility Index as well as VIX futures, you can refine your interpretation on not only the current volatility landscape, but perhaps where future volatility may likely be heading.

Many analysts believe that this extreme low volatility environment will most likely be short lived rather than extended -- and also expecting volatility to move up significantly higher than its mean average.

The following Table and Graph show the term structure of the VIX spot and VIX Futures:-



VIX-2-031512



VIX-3-031512



From the graph it can be seen that “Spot” VIX closed Wednesday at 15.31, which is indicative of low investor fear and a continued optimistic outlook.

However, it is important to look a little deeper on how the “smart money” is pricing future volatility; the picture it paints is quite different. In fact, the term structure across the delivery months is extremely steep!

The VIX April futures are not only 40% higher than Spot, but also above the long-term mean average -- in a few weeks we’ll get into Q1 earnings season.

The VIX July futures are even higher -- with six-party talks set to get under away and potentially a last ditch effort to find a diplomatic solution regarding Iran’s nuclear program, maybe, if necessary, the window of opportunity if a military strike is carried out.

And the VIX November futures are extremely elevated, nearing almost 30, which is a historical level of heightened volatility -- the US will be going to the polls to determine who will control the White House for the next four years.

Conclusion

The bottom line is that paying close attention to volatility is very important!

Most average investors do pay some attention to the CBOE Market Volatility Index, but if you want to really up your game and obtain master “market feel” status – and benefit on the profit margin -- start to look a little deeper into the future... sometimes you’ll be surprised at what you may find!

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