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October 11, 2012  Thu 9:08 AM CT

VIX: SEE CHART GET CHAIN FIND STRATEGIES
Why has the VIX been so low even when markets sell off?

When the CBOE Volatility Index surged from 14 to 17 within the span of just two sessions recently, TV anchors were saying that their top story was the jump in the so-called fear index from nearly five-year lows. But the VIX remained well below its long-term average around 20 and even its 200-day moving average at 18.55.

All of this begs an obvious question: Given all the turmoil in the world and on the horizon, why has the VIX been so low? And was that 48-hour move too much or not enough?

Let's start with the basics. The VIX is not a "fear index," though it does, sometimes, correlate with fear. It is a volatility index, and it always correlates with the actual volatility in the market.

The actual volatility for the S&P 500 has been below 10 percent, so a small premium in the VIX above that is normal. The volatility that we have seen in the last several months has come from big rallies, which is unusual. If we were to look at downside volatility in the SPX, it has been essentially non-existent.

So in reality the VIX has been consistently showing the expectation that volatility will double. There is also a popular sentiment that is keeping volatility--both realized and expected--low: that the Fed will not let the market drop. That was clearly expressed by one guest on CNBC this morning who said, "The Fed's there to support us."

The latest pop in volatility reflects the same issues. A shift of 1 percent in the SPX means a volatility level of roughly 16 percent, so the move to that level is no big surprise. What it does suggest is that traders don't expect that that level of volatility to continue. If they did, the VIX would have moved higher, again reflecting the volatility premium that sellers demand.

At the time of that 48-hour jump in late September, the VIX futures did carry higher premiums. The October futures were trading at 17.50, which means that traders were betting that the volatility index would be at that level at the October settlement, and the November futures traded at 18.80. But this rising premium in the futures, known as "contango," is perfectly normal in these cases and is to be expected when the market is trending higher.

Does this mean that the VIX is reflecting complacency? No. It is signaling a collapse? No. What you should keep an eye on is moves of 1 percent or more in the market. And if the VIX exceeds the futures--in "backwardation," the opposite of contango--that often is a bad sign for equity markets. Volatility begets volatility.

As for the Fed holding up markets, I am not so sure about that thesis. And if people are forced to give up that belief the hard way, things could get ugly in a hurry. Oh, and then there is that fiscal cliff…

All in all, I do think that "buying volatility" at these levels makes sense. You can't buy the VIX itself, of course, and buying VIX-related funds doesn't make a lot of sense because the futures premium makes them expensive.  

So buying index and ETF puts seems to be the way to go to build up some long-volatility positions for protection. Like most insurance, you may not want to pay for it, but it can come in handy if you end up needing it.

(A version of this article appeared in optionMONSTER's Education Newsletter of Sept. 26.)
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