Getting a fix on the VIX

Below is a chart of the VIX daily vs. a rolling percentile ranking +/- 3St Dev. This is a simple way to look at implied volatility that I often use in FX land,  but in this case I am applying it to the VIX index. Based on this very simple indicator, and as is known to just about anyone knows who pays attention to the financial media, the VIX at the moment,  is cheap. Another key indicator you can grasp easily from the chart below is when the distance between the Percentile highs and lows narrows it represents a  compression of the vol of the VIX, and as it expands the vol of the VIX is rising.  As you can see below while the gap currently is   narrow there have been two other periods when the gap has been tighter still. So, while the VIX may be close to an extreme low, the vol of the VIX is not yet at an extreme.  

And below is the proof of what we surmised just by looking at the chart above. The chart below is the three month actual vol of the VIX; currently just over 80 but it generally bottoms around 60. What may well be more important is that it is clearly in a downtrend having taken out some support around the 90 level. 

  

The next chart is the VIX plotted against the daily momentum of the VIX. Notice too, not surprisingly the momentum trend is down. However, as you can also see the most recent trend had been rising quite steadily from 2013 until it formed a nice double top in 2016 and broke the trend line and now is testing levels just aboe the previous cyclical low.  Since we are not too far from the historic VIX lows, momentum is going to find it a bit of a hard slog to move much lower from here, and may in fact start to find a bottom. 

The next chart might involve a bit more controversy, from any conclusions we may try to draw. It is the rolling 55D and 143D correlations of the VIX and the S&P 500. As you can see, and not without too much surprise, in general the S&P and the VIX are negatively correlated. The VIX tends to contract in periods of equity trend expansion and expand in those sharp short periods of equity market weakness. The interesting thing about this chart, is the current weak negative correlation between the VIX and the S&P. It is still negative, no doubt about it, but is is showing the least negative readings in years. Well, it may just be telling us nothing more than what the momentum chart above is suggesting, namely that the VIX can go lower on higher equity prices, but the room for contraction is limited. The other possible explanation is the market short covering gamma positions produced from the sharp rise in the S&P. 

The other factor that may be holding up the VIX is the skew,  which is also not at a compressed level as out of the money options get bid up for protection purposes. 

Apologies for the busy chart below but this is the VIX plotted against the CBOE Skew index which attempts to measure the degree of skew in option prices. And as you can quickly see from the chart below, while the VIX is close to a low, the SKEW is elevated. In fact the skew, recently traded up the its limit at 150 indicating very robust demand for downside protection. The easy conclusion to draw from this is that the skew is not worth owning at these levels, and that option based hedge strategies should incorporate shorting some skew against ones longs. The most obvious trade is put spreads, but there are other variants as well. 

Finally, the next chart below is the S&P 500 daily plotted against the VIX as well as the actual vol of the S&P calculated using a variant of the Parkinson statistic(using the daily Hi and Low of the S&P as apposed the the close to close values). This chart demonstrates that the spread between the VIX and Actual Vol (AV) is almost universally positive and the only times they narrow substantially is following a VIX spike where the VIX declines faster than the AV. Apart from those instances the spread is positive. Another way to asses the cheapness of options is to do the same percentile ranking exercise on the IV-AV spread. At the moment it is running at around 0.66. This is with the VIX at 11.49, the AV at 5.24 and the spread at 6.25. Ideally, it would be better to see the spread below 0.25. In other words the criterion would be less than 3stdev below the rolling percentile rankings, and in the bottom quartile in terms of IV-AV spreads, and some clear signs of momentum exhaustion. 

The final chart blow is the S&P vs.my daily momentum indicator. As this chart demonstrates, momentum is just breaking above the previous highs prior to the financial crisis in 2008 and above the levels recorded just prior to the August sell of in 2011 but below the more recent highs seen in 2014. Whether we see those levels again is still in doubt but momentum is clearly trying to trend higher still. 

Taking all these indicators together in sum, it is not unreasonable to expect some sort of S&P correction. 

This  may not be a secular top (unlikely) but more probably, a top that leads to some sort of 10% or as much as a 15% correction. In a more ideal scenario, we would like to see the skew get sold off as well, as it is in periods of total capitulation that the market starts to sell any sort of premium it can find. However, we are not there yet, and more likely, we may not get there. So, any downside hedge or spec trade should try to short some skew in the process. That, as I mentioned above suggests buying put spreads, or ratio put spreads. For example buy 3X ATM puts and sell 2X 25 Delta puts. On a 10% correction roll out of the put spread 2 by 2 and leave yourself long one in-the-money put as a running hedge. Secondly idea is similar. Buy 3X ATM puts sell 2X 25 delta puts, and buy 1X 10 delta put. If you get the 10% sell off sell all of the put spread, and leave yourself long the 10 deltas as a hedge. And the expiry of these options should be long dated in my view. Consider Sept or Dec 2017 expiration with lots of time to work in your favor. And in terms of execution work out the mid mark prices and then leave bids still lower. Let the market come to you. 

-James