Beware of a Plunging VIX in the Summer

by Daniel Putnam | July 23, 2013 8:25 am

Beware of a Plunging VIX in the Summer

When most people think of summer, vacations and beach trips are the first things that come to mind. But if you’re reading this article, chances are “summer” to you means low trading volumes, sleepy Fridays and stretches of low volatility.

Very often, this low volatility has led to sharp downturns in the CBOE Volatility Index (VIX[1]) in the July-August period. But don’t let this lull put you to sleep: More often than not, a low VIX in the summertime has been a signal that caution is in order.

This is an important consideration right now, as the spot VIX has taken a dive in the past month to close at 12.29 on Monday — not far from its 52-week intraday low of 11.30, set on March 14 and 15. For investors who are already in the market, this has been great news: Since the most recent peak in the VIX on June 24, the S&P 500 Index has tacked on nearly 8%.

At this point, though, history indicates that we should be watching out for some red flags.

Trouble Ahead?

From 1990 through 2012, the VIX hit or approached its low for the year in the warm-weather months on 16 occasions. Fourteen of those times, the low was followed by a spike before the third quarter was over.

In some cases, such as 1993 and 1999), the downturn in the VIX simply signaled a short-term trading opportunity:

1993 Beware of a Plunging VIX in the Summer[2]

1993

1999 Beware of a Plunging VIX in the Summer[3]

1999

On several other occasions, however, the summer low was followed by a more sustained upward move that persisted well into the fourth quarter (most notably, 1990, 1997 and 2011).

1990 Beware of a Plunging VIX in the Summer[4]

1990

1997 Beware of a Plunging VIX in the Summer[5]

1997

2011 Beware of a Plunging VIX in the Summer[6]

2011

Only twice, in 1991 and 2009, was the summer low followed by a benign environment in which the VIX stayed low without interruption through the summer and into the fall.

In fact, a look back over the 1990-2012 period shows that the VIX rose in the August-September interval on 14 of 23 occasions, with an average gain of 13.1%. Nine of those times, the index registered a gain in the double digits.

Picking the exact low is next to impossible, of course, but with the VIX deep on the low end of both its historical and recent ranges — and within striking distance of its March low — there isn’t much room for additional downside from here.

While the risk-reward equation in the VIX is asymmetrical right now, that doesn’t mean it’s time to purchase the various ETFs designed to capitalize on rising volatility. These products have been — and remain — extremely inefficient ways to play the VIX[7] due to the persistent losses that stem from the need to “roll” the funds’ positions into longer-dated, higher-priced contracts. That hasn’t stopped investors from trying, however: Long-VIX ETFs have experienced inflows since the beginning of July, paced by the $390 million hauled in by iPath S&P 500 VIX Short-Term Futures ETN (VXX[8]).

Even though VIX ETFs might not be the answer, historical patterns indicate that right now is an outstanding time to trim winning positions or purchase protection on the cheap.

The combination of the low VIX, seasonal factors, a record high for the S&P 500 and the strong rally in stocks over the past four weeks all underscore the need for a conservative approach from this point forward.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. VIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VIX
  2. [Image]: http://investorplace.com/wp-content/uploads/2013/07/1993.jpg
  3. [Image]: http://investorplace.com/wp-content/uploads/2013/07/1999.jpg
  4. [Image]: http://investorplace.com/wp-content/uploads/2013/07/1990.jpg
  5. [Image]: http://investorplace.com/wp-content/uploads/2013/07/1997.jpg
  6. [Image]: http://investorplace.com/wp-content/uploads/2013/07/2011.jpg
  7. extremely inefficient ways to play the VIX: http://investorplace.com/2011/06/volatility-etfs-the-worst-trade-around/
  8. VXX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXX

Source URL: http://investorplace.com/2013/07/beware-of-a-plunging-vix-in-the-summer/
Short URL: http://invstplc.com/1fsgs3i