Concerns Surrounding the VIX Volatility Index

September 27, 2011

It is becoming more obvious, due to the positioning of the VIX, that options traders expect Europe’s debt crisis to engulf the U.S. as contracts to protect against losses in the Standard & Poor’s 500 Index erase the gap with the euro region’s benchmark gauge.

The Chicago Board Options Exchange Volatility Index increased 33 percent last week to 43.82, bringing it within five points of the 29-month high reached Aug. 8. The VIX, as the gauge is known, has eliminated more than half the discount to Europe’s VStoxx Index in the past week, cutting it to 7.3 points from 15 on Sept. 12.


Traders are showing less confidence American equities can avoid losses that drove shares in Germany, France and Spain down more than 30 percent as the 18-month debt crisis threatens to spur the second global recession in three years. The S&P 500 fell 6.5 percent last week, the most since Aug. 5, bringing the loss from its 2011 high to 17 percent.

As the situation deteriorates, the U.S. and U.S. volatility are starting to catch up to reflect the stress being built up in Europe.

Global stocks entered a bear market on Sept. 22 when the MSCI All-Country World Index slid 4.5 percent, bringing its decline since May 2 to 22 percent. Benchmark gauges in at least 32 markets, including Hong Kong and Australia, have declined 20 percent or more.

The VIX and the VStoxx

The VIX, which has averaged 20.4 in its 21-year history, touched 48 -- the highest level since March 2009 -- on Aug. 8 after S&P stripped the U.S. of its AAA credit rating. The gauge fell 5.4 percent to 39.02 in New York yesterday. The VStoxx Index, which measures the cost of protection against losses on the Euro Stoxx 50 Index, climbed roughly 14 percent to 51.42 last week.


The Dow Jones Industrial Average (DJIA) fell 738 points last week to 10,771.48, the most since October 2008, as investors speculated central banks are running out of tools, such as the implementation of “Operation Twist" to prevent a recession. The U.S. Federal Reserve said on Sept. 21 that it will replace $400 billion of short-term debt with longer-term Treasuries to spur growth, and said there are “significant downside risks” to the economy. The Stoxx Europe 600 Index sank 6.1 percent.


The VIX Reflects Consumer Confidence

U.S. consumer confidence dropped last week to its lowest point since the recession ended in 2009, and European service industries and manufacturing contracted in September for the first time in more than two years.

The VIX climbed above 30 on Aug. 4 and has stayed there for the 36 days since, a period of elevation that has foreshadowed economic deterioration in the past, according to UBS AG. When the VIX climbed above 30 five times between May and July 2010, it never stayed above the level for more than nine days in a row.

The Future of the VIX

For the VIX to settle back down, optimism on a European debt solution needs to grow, as well as appropriate third-quarter earnings guidance to instill confidence in the market.

The S&P 500 has fallen 68 percent since March 2009. The benchmark gauge for American common equity is trading at 12.4 times earnings in the past 12 months, 4.4 percent below its average valuation at the lowest point during the last nine bear markets.

Companies in the S&P 500 are forecast to report third- quarter earnings that are 14 percent higher than a year ago, according to analyst estimates. Profits will climb 18 percent to $99.33 a share for 2011 and reach $111.08 in 2012, the data show. Companies had a record $2.05 trillion in cash and short-term investments at the end of the second quarter, the U.S. Federal Reserve said Sept. 16.

Where to Invest

The U.S., relative to world markets, seems to be the place to invest as issues encountered in the U.S. are being tackled and dealt with to greater degree than that of Europe.

U.S. Treasury Secretary Timothy F. Geithner said at the annual meeting of the International Monetary Fund in Washington that failure to combat the Europe turmoil threatened “cascading default, bank runs and catastrophic risk.” Billionaire investor George Soros said Sept. 24 that “something needs to be done” to safeguard Europe’s banks as Greece, which has yet to secure a second bailout, may be unable to avoid default.

While the IMF vowed to “strongly support” Europe, Managing Director Christine Lagarde said in a plan distributed to the IMF steering committee on Sept. 24 that the Fund’s $384 billion lending chest may not be enough to meet all aid requests if the world economy worsens.

Where to Now?

It’s fear of the unknown at this point, which is driving the “fear indexes to extremes! If Greece defaults, it’s a counterparty exposure to the financial system in Europe that can create some level of contagion into the U.S. financial system.

Implied volatility, the key gauge of options prices, for S&P 500 contracts at the current level expiring in three months jumped to 34.4 on Sept. 22, the highest level since April 2009. It closed at 33.17 the next day. For options on the Euro Stoxx 50, implied volatility fell 5.3 percent to 39.78 on Sept. 23, from its 30-month high of 42.01 Sept. 12.


VIX futures began trading at 8 a.m. New York time and will do so every weekday effective today, the CBOE Futures Exchange said in a Sept. 23 statement. The change from the previous 8:20 a.m. start time provides “more time to establish or offset VIX futures positions surrounding potential market-moving events” before the equity market opens, the statement said.

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