Don’t Be Fooled by the VIX

The VIX exaggerates fear levels on Mondays

On Monday, the CBOE Volatility Index (VIX) opened up about 5%. The market did open slightly lower, but basically hovered close to unchanged for the first few hours of trading. Yet the VIX held onto its gains.

So is this another sign of impending doom we can file alongside the steep VIX futures term structure and the heavy skew toward out-of-the-money (OTM) puts?

I think not. I believe this is a confluence of quirks that would lead one walking into the market today to see fear where not all that much exists. But you have to go back to Friday to put this in better perspective.

A trader on Friday afternoon does not want to pay full fare for an option knowing he faces three days of price decay before the market re-opens on Monday. So he lowers his bids a smidge. The VIX estimates the volatility of a hypothetical S&P 500 (SPX) option with 30 days until expiration, but a trader in the real world would view that option as if it only had 27 or 28 days remaining. That has the effect of lowering his bid on Friday, in volatility terms.

We come back Monday, and voila, it’s three days later on the actual calendar, but maybe zero or one day later as far as the options trader is concerned. He has already priced in the weekend decay on Friday, so the SPX option itself might not be much lower in actual dollars. But it’s higher in volatility terms and, thus, translates to a higher VIX on Monday.

This doesn’t always happen. We get some scary Friday declines, and at those times, traders are less concerned with a few days of decay than they are with a big Monday gap. In fact, you see almost the diametric opposite on those Fridays as the VIX goes into overdrive. But, in the absence of that sort of nervousness, we tend to see Friday VIX dips and Monday VIX strength.

Can You Trade This VIX Quirk?

Something else we need to note: There’s no VIX trading opportunity associated with this pattern. You can’t trade the actual VIX. In fact, this is exactly why there’s no “spot VIX” to trade.

The iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) is the closest VIX proxy, and weekend quirks have no impact on it. VXX may or may not sell off with the VIX on a slow Friday, but if it does, that’s a “real” decline in volatility assumptions, not a function of the clock and the calendar.

Follow Adam Warner on Twitter @agwarner.

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Article printed from InvestorPlace Media, https://investorplace.com/2010/08/vix-reading-inflated-on-mondays/.

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