That Odd VIX Action

• Posted by Adam Warner
• on January 27th, 2010

My favorite “shrink” Phil Pearlman asked yesterday whether the VIX dip on a day with an SPX dip meant anything.

Short answer is that in general it does, it’s a negative divergence. I really look for 2 things with VIX, one is deviation from the “mean”. “Mean” is not necessarily a moving average, though that’s a good proxy. It can also refer to the relationship between implied volatility and realized volatility of the underlying. If implied is way away from realized and there’s no easy explanation (such as earnings on tap, Fed news, et. al.) I’d define that as deviation.

Another thing I look for is divergence from expectations. If the market implodes and the VIX explodes, I would suggest the VIX tells you nothing you couldn’t infer without it. But if the market implodes and the VIX yawns, now we’re gleaning some info.

In that context, let’s look at the last week or so of VIX action.

We saw about a 6% dip or so in the market in about 3 trading days. That’s a decent pullback, but hardly a crash. Yet the VIX lifted 50%. That’s a wild over reaction imho when you consider that even at it’s lows, the VIX was NOT too cheap relative to the actual volatility of SPX. 10 Day HV of SPX was about 10 from mid December to mid January. VIX as you can see on the volatility graph here of the last 3 month’s. The VIX at 27 was a wild divergence from both expectations and the “means” as defined by the 10 day moving average and realized volatility. In other words, WAY overbought. Again, overbought does not always work as a buy signal (see 2008) and in fact this one hasn’t really worked yet either, all that’s happened is we stopped going abruplty lower.

Which brings us to yesterday. We didn’t rally, but we haven’t crashed so far this week either. There was no terrorist incident in England and Bernanke looks like he’ll get re-upped, two big fears of last week (yes, it’s ridiculous to include terrorism and Bernanke’s job status in the same sentence). In a vacuum, the VIX shouldn’t have declined on yesterday’s SPX action, but coming off a huge spike in Fear, it does make more sense.

So yada yada yada, my overall opinion is that even though we worked off some excess apprehension, the VIX is still a bit elevated here. I suspect we could see more odd action until this settles out.

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