It’s pretty rare to see utter complacency and abject fear at the same time, but if you look closely at all things VIX, that’s what we see right now.
Complacency? Check no further than the VIX itself. Despite the odd strength in Monday’s final hour, the VIX closed a healthy 19% below its 10-day simple moving average (SMA) on Tuesday. Anything under 10% is considered oversold; under 15% provides some decent market shorting signals. What’s more, Relative Strength Index (RSI) hit an absurdly low level of .76 in the 2 o’clock hour.
As we’ve noted previously, the VIX works best as a short-term countertrend play. In other words, if you believe the current rally is a lift within a longer-term down market, then selling the market into an oversold VIX makes sense.
But before you go buying up inverse ETF’s, consider this: We’re also seeing nearly unprecedented fear.
October VIX futures carried a $7 premium to the VIX as of Tuesday’s close. It’s tough to say whether that’s a record or not as you’d need a constant duration future measure, but suffice to say that it’s in the ballpark of the highest levels of premium for a future with three months remaining. And this is slightly down from the $8 premiums of Monday night.
Throw it all together, and it’s safe to say the market expects a relatively docile summer in terms of volatility, followed by an exciting fall. That is, of course, very normal behavior. What stands out, though, is the sheer magnitude of the expected volatility pop.
In theory, you would want to “fade” this spread, that is buy near-term options (or VIX futures) and short longer-dated ones. The problem is there’s no saying the disparity has to contract.
July-August VIX options are not particularly cheap when compared with the realized volatility in the market (accounting for a recent blip up thanks to the big percentage move higher on July 7). October-November VIX options do look too high, in my humble opinion, but just shorting them and crossing your fingers carries enormous risk, so I’d only use spreads if I planned to make this trade.
Follow Adam Warner on Twitter @agwarner.
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