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January 10, 2013  Thu 8:40 AM CT

VIX: SEE CHART GET CHAIN FIND STRATEGIES
In the last few days, a steady stream of guests on financial TV have pontificated about the CBOE Volatility Index and what it means. Most of them apparently don't know what they are talking about, but the fiscal-cliff volatility and subsequent record drop in the VIX have provided plenty of fodder nonetheless.

Let's start with some recent background. Toward the end of 2012, the VIX was down as low as 15 even as the so-called fiscal cliff was rapidly approaching. The volatility index then rocketed above 23 in the last two days of the year as traders finally started showing concern that a budget deal might not get done.

The VIX then saw a huge two-day drop, which some have called its steepest in 25 years. But the VIX was created in 1993, so it isn't even 20 years old. And in its current form, it has been around only since 2003. (It used to be based on at-the-money options on the OEX but is now based on a much wider range of options on the S&P 500.)

This morning it hit 13.22, the lowest level since the middle of 2007, and the pundits have come out in force. Here are just a few snippets from the last 24 hours:
  • "When volatility goes up, we know stock prices go down."
  • "We are looking for all-time lows on the VIX."
  • "We like buying VIX call options in February."
The first one could be interpreted a lot of ways, but the speaker was pretty clearly implying a rising volatility causes stocks to fall. That is simply false; if there is any causation, it is the other way around. Yes, there is typically more volatility in down markets than up markets, but a rising VIX doesn't "do" anything to stocks.

The all-time lows for the VIX came in late 2006 when it was down near 9 percent. But we have to remember that the VIX is most closely tied to and correlated with the actual volatility of the SPX. Typically the VIX carries a premium of 3 percentage points over the actual volatility of the SPX, but recently it has been much greater when actual volatility is low.

The lows for the 30-day historical volatility for the SPX came back at the end of February, when it got as low as 7.9 percent, but the VIX at that time was 14. And the low for the 20-day reading was 6 percent at the start of September, when the VIX was above 15.

Given those premiums, the actual volatility of the market would have to get down to roughly 4 percent to get a VIX reading of 9 percent.

I just don't see that happening, and I don't see option sellers taking premiums that low even if it did. Just this morning when the S&P 500 was up, the VIX bounced off its 13.22 low and is higher by 1.25 percent at the time of this writing.

Now onto the last of the three remarks listed above, about buying VIX calls in February. Just now another commentator said it is time to buy protection because "the VIX is as cheap as it has been in five years." I don't disagree with that last statement, but we need to be careful here.

For one thing, we can't "buy the VIX," as the volatility index is not directable tradable. We can buy VIX futures, options, and exchange-traded products that based on them. But with the VIX at 13.79, the February futures are trading at 16.55--a 20 percent premium to the VIX itself.

The same can be seen in the SPDR S&P 500 (SPY) options, another vehicle that traders often use to buy protection. The at-the-money puts in the January expiration have an implied volatility of 10 percent, which is very low. But the February puts have an implied volatility that is 20 percent higher, and the rate for the March puts is 45 percent higher.

This doesn't mean that you shouldn't buy VIX calls or SPY puts, but I am highly partial to the latter given the volatility term structure right now. And I do think we will see higher volatility going forward because, as far as I can tell, the government hasn't really solved any issues yet.

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Jan. 8.)
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