Papale on the VIX

by Steve Papale

The heat dome.  The polar vortex.  These are two weather terms used to describe extreme heat or cold conditions around where I live.  I have heard of the polar vortex.  Pretty much extreme cold blasting in from the arctic or somewhere crazy cold in the winter bring our temps to insane below 0 temps.  Now we have The Heat Dome.  Very hot and humid.  I guess there is some kind of weather dome keeping hot weather over us.  Heat index somewhere around 100.  When are we going to get some kind of polar vortex air flow in the summer and a heat dome effect in the winter.  Come on polar vortex – we need you now – not in January.

Earlier this week, the VIX closed at the low of year, 11.77.  Ever since the Brexit selloff a few weeks back that saw the VIX spike to over 25, the VIX has drifted down, while the market rallied, to where we are now.  As we know the VIX or volatility index, is  a CBOE product that tracks investor sentiment of future volatility of the market.  VIX is calculated by looking at the implied volatility of various SPX options.  What is interesting to note is that while the cash or spot market for VIX is at yearly lows, looking forward over the next several months, the futures are telegraphing a higher level of VIX, which generally means lower stock market prices.

As for the case for lower prices, last August we had a significant selloff and markets may be remembering that.  Also September and October are traditionally weak months for the stock market.   That said, remember that VIX is a mean reverting index, meaning that unlike a stock, it must return to a “normal” level.  VIX cannot go to 0 so even if markets continue to rally, VIX must stop going down.

Finally, there is the possibility that since we are currently at all time highs in the market, the normal condition of complacency during rallies could be replace by nervousness focusing on not wanting to give up new gains.  If this is the case hedgers buy insurance to protect gains.   Whatever the reason, VIX progressively moves from its spot level of around 12 today to the mid 15’s at August expiration to close to 19 by year end.  Just something to think about as we head into the second half of the year.

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