Friday, May 30, 2014


Ciovacco Capital - stop wasting energy on the VIX.

Like I've been saying, the $VIX is not a "fear gauge". To the first approximation, it is an index purporting to measure the market forward expectation of implied volatility.

From Wikipedia, $VIX to the second approximation is:
[...] the square root of the par variance swap rate for a 30 day term initiated today. Note that the VIX is the volatility of a variance swap and not that of a volatility swap (volatility being the square root of variance, or standard deviation). A variance swap can be perfectly statically replicated through vanilla puts and calls whereas a volatility swap requires dynamic hedging. The VIX is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days. The VIX is quoted as an annualized standard deviation.
Which is explained marginally less painfully as:
The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period.[6] That is, index options are priced with the assumption of a 68% likelihood (one standard deviation) that the magnitude of the change in the S&P 500 in 30-days will be less than 4.33% (up or down).

The price of call and put options can be used to calculate implied volatility, because volatility is one of the factors used to calculate the value of these options. Higher (or lower) volatility of the underlying security makes an option more (or less) valuable, because there is a greater (or smaller) probability that the option will expire in the money (i.e., with a market value above zero). Thus, a higher option price implies greater volatility, other things being equal.
Which you still don't understand, because if you did you'd be reading some options blog instead.

But basically, what it really means is $VIX can be interpreted as measuring how much the markets think their positions might run away. So in a way it's measuring complacency, but not "complacency about the economy" or "complacency about the USD" or "complacency about interest rates".

But really, the "complacency" being measured is little more than a premium to an option price. So really, $VIX measures a premium.

Anyway, the article at Ciovacco says this:
The VIX is currently close to a historic low. If that means historic complacency, then logic would tell us that when the VIX rises from very low levels, it must mean rising fear and bad times ahead for stocks…right? That logic often holds in the markets, meaning the VIX can be and is a useful tool for stock investors. However, the strength of a stock market indicator lies in its consistency. Can stocks rise as the VIX rises from low levels? History not only says “yes”, but it does so emphatically. The chart below shows a period beginning in late 1995 when the VIX started to rise from low levels. The VIX surged from 10.36 in 1995 all the way to 38.20 in late 1997, which is a major spike in the VIX. How did stocks perform over the same period? The S&P 500 gained 47%…yes, that is not a typo…stocks gained 47% during a period when the VIX more than tripled.

For those scoring at home, the 47% move in stocks began when the VIX showed “a high level of investor complacency” with a reading of 10.36.

Yes, he's being overtly selective in selecting his high and low, but that's to illustrate his point: from 1995 thru 1997, you had to buy the $VIX low and sell its high.

One backtest and he's destroyed the rule of thumb that you sell the low $VIX and buy it high.

Always look under the hood, and always recognize that people in the media love to grossly oversimplify to make their story palatable. In this case, I'm not saying "$VIX of 11.49 is nothing to be frightened of"; I'm saying "it's a lot more complicated than that, and it's best to keep your mouth shut til you've done the math and seen what $VIX really is measuring".

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