Friday, October 11, 2013

Update #3: Doomsday Scenarios: It’s the Volatility of the VIX that is Our Signal; Not the VIX Itself

On 10-11-2013 the VIX spot is quoting at $15.47, down 6.1% with IV30™ down 3.0%. The LIVEVOL® Pro Summary is below.

VIX is the 30-day volatility index for S&500 options. It is also known as the fear index as it reflects future looking near-term risk in the S&500 index.

This is a follow up to two prior posts. You can read those posts by clicking on the titles,below:

10-8-2013: Follow Up; It's the Implied Vol of the VIX that is Our Signal; Did a Bi-partisan Congressional Vote Bring us to the Brink of Another Great Depression?

10-3-2013: VIX - Doomsday Scenarios; It's Not the VIX that Matters; It's the IV of the VIX That is Our Signal

Those articles surrounded the idea of whether or not (or how) VIX could be used as signal to the potential doomsday scenarios that were (and still are) being surveyed if the US government defaults on its national debt. Here are a few snippets from those posts (below), but the main conclusion I came to (which is my opinion) is that it’s not the VIX that is our signal, but rather than implied volatility of the VIX.  I still feel the same way.  But this time, there's some empirical evidence, and it's fascinating.

While the market is tumbling and panic may be setting in, I actually say, as of this writing on the close of Tuesday, that we're not in panic mode yet and I see that not in the VIX (which is ripping), but in the implied volatility of the VIX. Here are some snippets from the prior post:

The political stand-of will end. It might take a long time. The US may even default on debt payments (unlikely, but possible). A downgrade of US debt is more likely and remember, the debt rating is based on the highest rating. S&P already downgraded the US debt... What if Moody's does too?...

So let's walk along the string that looks to a catastrophe. Downgraded US debt --> defaults on outstanding debt. Then what? Will the country have a shutdown government forever?

My best bet would be no. If you want to get the real pulse of the market, you can look at the VIX, but it's the vol of the VIX that will really tell you where we are. If the implied volatility of the VIX breaches 115%, that would represent a multi-year high; and that could be a signal of a doomsday market reaction (but not necessarily a doomsday reality). Watch that number. If it closes above 115%, I think a market spasm is a real possibility b/c fear could overpower the market. Until then, I see posturing and fear of fear, but not necessarily anything else.

Let's take a look at the empirical evidence of late.

Let’s turn to the two-year VIX Charts Tab is included (below). The top portion is the spot price; the bottom is the vol (IV30™ - red vs HV20™ - blue vs HV180™ - pink).

So we can see two phenomena very clearly:
(1) The VIX spot exploded to ~40% as of two-years ago
(2) The VIX spot exploded recently due to the recent fear of the government … implosion… but we can also see that the VIX has dropped sharply in the last two days from ~21% to now ~ 15.5%.

But as I have said before, it’s not the VIX that has my attention it’s the IV30™of the VIX (the volatility of the VIX) that is my signal. Let’s turn to a two-year IV30™ chart of the VIX below in isolation.

Check out that recent spike on 10-7-2013. The IV30™ closed at 115.00% (yeah, exactly 115%) while the VIX itself closed at 19.41%. So, obviously another down day would have thrust the vol of the VIX up (as well as the VIX) and then we would be in doomsday, right? Not really. The following day the market dropped again and the VIX rose from 19.41% to 20.34%, but… and this is a huge one… the IV30™ of the VIX dropped nearly 14% to 101.88%. This was the day that I wrote: “we're not in panic mode yet.”

So, while the market was still struggling with the risk ahead and dropping on continuous days, the uncertainty surrounding the VIX was also dropping. The next few days have been…well, the next few days. The market has rallied, the VIX has dropped and the IV30™ of the VIX has dropped substantially to ~79% from a high of 115%. In other words, the IV30™ of the VIX was a forward looking indicator – as the market went down, and VIX rose, the IV30™ of VIX fell, and from that day forward we have rallied hard and VIX has fallen hard.

For now, we’re calm. Tomorrow, who knows? But whatever the case, watch the IV30™ of the VIX closely; if it pops above 115% and gets follow through the next day, I believe we could be in a paradigm where +/- 2% in one day on consecutive days is a possible (likely) outcome.

This is trade analysis, not a recommendation.

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  1. Hi, Ophir, as you mentioned "we could be in a paradigm where +/- 2% in one day on consecutive days is a possible (likely) outcome.", nevertheless, what one needs would be more precisely it's 2% up or down. Any clue?