How low can you go? This is a question that a lot of traders ask when the CBOE Volatility Index (CBOE:VIX), or the fear index, hits new lows again and again. This week the VIX hit 11.50, which hasn’t happened since 2007. That is pretty low and it indicates that fear of a large correction to the downside is proportionally low. With the recent disruptions in Europe looking more and more like a false alarm, this confidence seems justified.
Click to Enlarge Contrarians will argue that overconfidence is a big red flag that indicates that the market is likely to decline and that the correction should be very large. To a great extent we agree with that, but the problem will always be timing. The last time the VIX was at this level was in 2007, but it had been there since 2005. There was a two and a half year stretch when traders seemed legitimately “overconfident.” Eventually, contrarians were proved right, but how many of them were willing to remain short for that long?
It would be equally foolish to assume that anytime the VIX gets this low it means there is likely to be another 30-month bullish extension. The only real message from the VIX is that traders are confident and aren’t expecting a big move to the downside within the next 30-45 days. They may be wrong, but that is how expectations are currently set. On a day to day basis, speculation like this is probably not the best use of the VIX anyway.
The VIX is a measure of the average implied volatility levels of the short-term options on the S&P 500 index. If traders are confident, then implied volatility will be low. That means premiums will be lower on average as well. That is a good thing because it brings down trading costs for option traders. Traders can open more trades than they might be able to otherwise and extend the holding period because time value erosion will be slightly less of a factor. This is one of the changes we have made recently and plan to continue as long as the market remains accommodative.
Click to EnlargeThe perma-bear contrarians out there do have a few valid points that should inform our trading over the next few weeks. They will point out that although the VIX has been this low before, it doesn’t tend to get there just as the market is making new all-time highs. As you can see in the next chart, the VIX first reached these same levels in 2005 while the S&P 500 was still well below its 2000 highs. It left these same levels as it got to all-time highs, indicating the potential for a bearish turn in the market.
While the VIX’s current trend is unusual, it is not a cause for panic…yet. What we should be much more concerned about is when the VIX starts to rise up off these levels. Especially if that rise is happening while the major stock indexes are still rising. This was the situation that preceded the correction in October of 2012. We aren’t seeing that yet, but it is something that can happen in a fairly short period and should be monitored closely.
John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.