Daily Options Report

More VIX Wisdom from Bloomberg, so let's dig in.

Options traders are increasing bets that the steepest rally in the Standard & Poor’s 500 Index since the 1930s won’t survive September, historically the worst month for U.S. equities.

Traders are betting the VIX, a gauge of expected stock swings, will increase 13 percent in the next five weeks, according to futures prices compiled by Bloomberg. That’s the biggest spread since August 2008, right before the S&P 500 suffered the steepest two-month plunge in 21 years. The indexes have moved in the opposite direction 81 percent of the time over the past five years, Bloomberg data show.

Well, I can't graph a perpetual VIX future vs. VIX, so can't disprove that VIX futures have the biggest premiums since August 2008. But I suspect that statement is innaccurate as VIX futures premiums overall have eroded over the past month. What I can do easily is show you VXX vs. VIX over the past half year. VXX is an ETN that attempts to track a constant duration 30 day VIX future, so it's a pretty good approximation. And as you can see, this relationship has indeed caved since early July. Right about when everyone started noting the rather large VIX futures premiums.

So at the very least we can see this relationship has (innaccurately) predicted a volatility rally and (innaccurately) predicted a market implosion for a month now. It may eventually become an accurate prediction, but at some point it's like the inverse of all those serial bottom callers that took an awful lot of pain before actually getting it right.

It's also worth noting that VIX futures are relatively new. The VIX seasonally troughs in summer and then picks up again in Fall. A VIX future represents a bet on where the VIX will be on the day the future expires. Isn't it logical then that a VIX future with a Fall expiration would trade at some sort of premium to the actual VIX during the summer? I suspect that over the passage of time, we'll see a VIX futures premium almost every summer.

Case in point, this example he uses from last summer.

Options strategists saw the same upward-sloping curve last August, before the S&P 500 tumbled 9.1 percent in September and 17 percent in October. VIX futures two months from expiration were 4.11 points higher than the VIX on Aug. 22, when the index slumped to an 11-week low of 18.81.

This is where my head starts spinning. All the October futures "predicted" last August 22nd was that on October expiration day, the VIX would lift from a pre-Labor Day options tough to about 23. In reality the VIX was closer to 80 last October. To say a perfectly logical expectation that volatility would oick up a little after the summer somehow "predicted" the carnage that was to follow is a terriblly misleading takeaway here. Let's say you assume Total Mean Reversion. That is the futures are absolutely correct, and "cash" will go there. At best then, the futures anticipated a VIX lift from 18.81 to 22.92 over the course of about 2 month's. And part of that premium was simply a pre-holiday "cash" VIX understatement of actual volatility.

Just too silly.

Here's the volatility picture right now in a nutshell.SPX Index options volatiltiy, of which the VIX is the proxy everyone uses, overprices realized volatility of the SPX itself. By a large margin right now, though the relationship is ever-changing. SPX options are also high relative to individual stock options, although that relationship depends more on correlation. VIX futures overprice the VIX. So throw is altogether and VIX futures anticipate a rather large pickup in index volatility. And (presumably) an even larger pick-up in individual stock volatility.

Is this high VIX "smart money" and bearish or excessive Fear and bullish? The author here assumes the former. But if you've ever seen the "Odd Couple", you probably know what can happen when you assume too much.

....Oh, and one other thing.

The VIX, as the Chicago Board Options Exchange Volatility Index is known, usually moves in the opposite direction of the S&P 500 because demand for insurance rises as stocks fall. VIX futures expiring in September were 3.29 points higher than the index on Aug. 7, and last month were as much as 5.91 points higher, a record gap for so-called second-month contracts. Last week’s spread was comparable to the one in August 2008.

Aside from contradicting the earlier point that we were at some sort of futures premium not seen since August 08, it's also not a "so-called second-month" contract. September IS called a second-month contract. At least until August expires.