For months, we have been warning about an overconfident Fed and a VIX near multi-decade lows; while becoming increasingly bullish on gold. On two separate occasions over the past 100 days (here and here), we drew attention to the historically low VIX. In both cases, following our reports, the VIX exploded from around 10 to over 15 in massive moves, the most recent greater than 50%.
N.B. Defined by Investopedia, “VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.”
With VIX volatility increasing, collapsing nearly 20% this past Monday and then rising roughly 30% on Thursday, uncertainty is picking up as it did in the earlier years of the financial recovery… although it can be stomach churning for many passive investors, these swings are synonymous with trading opportunities.
VIX Predictions Come True as Volatility Surges
Our first report of 2017 highlighting the VIX took place on May 14th. Below is an excerpt from VIX Rallies 46.38% as Investors Panic – Our Prediction Comes True in 3 Days, written just a few days later:
“On May 14th, we published a Weekly Volume titled Why the Stock Market is Set for a Dramatic Swing. Today, on May 17th, we got that swing. US equities collapsed and the VIX, which was the focus of our entire report, had its biggest day in almost a year.
The report focused on the VIX (CBOE Volatility Index), also known as the ‘fear gauge’ of the market, which had recently fallen to a 23 year low. We warned that this lack of perceived risk could not last and today it came to an end as the VIX exploded 46.38% up 4.94 points to 15.59. Check out an excerpt from our exclusive report below:
“Today, we are focused on what can happen to the VIX, and, more importantly, the markets after a prolonged period of little to no perceived risk.
Market participants are pricing in the lowest volatility in 23 years! Should we believe it? Of course not.
If the aftermath following the previous three times the VIX was this low is any indication of what’s coming next, buckle up.”
Click here to read Why the Stock Market is Set for a Dramatic Swing, which has quickly turned into one of our best calls of the year.”
Our Second VIX Warning Came in Late July
The VIX ultimately sold off again, to even lower lows this July; but, once again, we highlighted the potential dangers of buying into the low perceived risk. Therefore, on July 26th, we published VIX Falls Below 1993 Record Low | Fed Preps to Normalize Balance Sheet. Our report stated,
“Wall Street’s ‘fear index’ the VIX fell below 9 following comments by the Fed. Let’s put this new record low of 8.84 into perspective. It was way back on December 27th, 1993 when the VIX traded so low – hitting 8.89. The market loves the Fed and loves Trump. U.S. stocks were already at new records before the Fed released its latest monetary statement. Everyone is now wondering the same thing… can it last?”
We got our answer just over one week ago as the VIX went parabolic, rising above 15 to a high of 16.61 on August 11th.
Certainly, the combination of monetary policy changes and asset unwinding from the Fed is our biggest reason to believe the VIX will gyrate rather dramatically in the months ahead. Although rate hikes may be priced in, few are considering what could happen when the Fed unwinds its highly criticized asset purchases.
VIX Knows When Investors are Asleep at the Switch
With implied volatility, there is a correlation between the VIX and the S&P 500. However, the VIX tends to overstate real volatility. While commonly referred to as the ‘fear gauge’ of the market, as with many things in life, fear (the VIX) itself is often the only thing to fear. So, the VIX reacts to the S&P 500, but is not a pinpoint accurate forecaster of future volatility. Check out the below chart:
At times when perceived risk is historically low, common sense suggests that an unforeseen event will spark caution and a spike in the VIX. Periods of prolonged complacency (a low VIX) lead to abrupt shifts in sentiment. One of the latest examples of this is North Korea and the rather far-fetched threat of nuclear war. Another came on Thursday when the VIX shot up 30% after the Barcelona terrorist attack – the U.S. markets had their worst day in three months.
S&P 500 and Trading the VIX
There exists a negative relationship between the S&P 500 and the VIX. When the S&P 500 reverses into decline, the VIX rises. Historically speaking, the VIX usually moves 4 times as much against the S&P 500. Sometimes it can react even more.
The head of Tasty Trade’s Research Team, Michael Rechenthin, Ph.D., aka Dr. Data, explained,
“Most of the variation of the movement in the VIX is explained by the S&P 500…”
“So, if you have this move of down -5% on the S&P 500 you can then just kind of go up to where this line crosses and you would tend to see about a 30% increase in the VIX.”
The daily relationship between prices and implied volatility is explained further in The Skinny on Options Data Science episode, which aired in late 2016.
VIX Volatility Increasing Despite Market
On August 14th, one of those ‘outlier dots’ occurred:
The S&P 500 Index climbed 24.50 points or 1% to 2,465.82 Monday. The VIX dropped nearly 20% on the same day, or 3 points to 12.35.
What’s so perplexing about today’s market is that the VIX sometimes swings aggressively up or down, yet major exchanges move very little from a percentage standpoint. This is likely due to the growing uncertainty in global geopolitics. As we neared the close Tuesday for example, the VIX declined 3.4% to 11.91, while the S&P 500 was up only 0.05%. Again, as fear from a potential nuclear event with North Korea fades, calm washes over the markets and the VIX declines.
One reason for the recent disconnect between the correlation of the VIX to the S&P 500, is the low volatility on the S&P itself. According to CNBC,
“…the S&P 500 Index hasn’t seen a 5 percent pullback in over a year, its longest streak without such a decline in more than twenty years.”
According to LPL Financial’s Ryan Detrick,
“This is only the sixth time since 1950 that the S&P 500 has made it at least a year without so much as a 5 percent correction, and marks the longest streak since 1995.”
This year, the VIX has averaged approximately 11.54 through mid-July. That is the lowest average level recorded since the CBOE implemented a new methodology calculation for the index roughly 14 years ago. That in itself should spark contrarian thoughts…
Finally, we don’t expect the markets to settle back into an extended calm for the remainder of the year. Expect dramatic swings in the VIX throughout the fall.
All the best with your investments,
PINNACLEDIGEST.COM
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