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Friday, September 17, 2010

VIX Curve Whacked

Bill Luby (of Vix and More blog) details in Barrons what a steep VIX forward curve implies (also detailed previously on EconomPic):

When it comes to the Chicago Board Options Exchange's Volatility Index (ticker: VIX), however, investors have much more difficulty getting their arms around what an elevated VIX means. With the "cash VIX" (the widely quoted index) hovering around 22, many are struggling with how to interpret the meaning of VIX futures that are calling for a VIX of 32 in 2011.

So what does a VIX of 32 foretell?

In terms of a strict definition, a VIX of 32 means that approximately one-third of the time the Standard & Poor's 500 index (SPX) will have a daily change of at least 2%. To put the 2% figure in perspective, during the last 20 years the SPX has experienced a daily change of 2% a little over 7% of the time. Even during tumultuous markets in 2008, when stocks experienced unprecedented volatility for an extended period of time, daily changes of 2% or more occurred less than 29% of the time.

Seen in this light, the VIX futures are predicting that 2011 will bring volatility that is comparable to what was experienced in 2008, a year of financial calamity.
How does this 32 level compare to historical "actual" levels?

Taking the rolling 12-month standard deviation of daily returns of the S&P 500 (annualized) going back to 1950, we see that a realized 12-month volatility level of 32 has only happened on two occasions:

1) 1987-88, which is the period that includes Black Monday (i.e. a 20% market crash in a single day)
2) The recent financial crisis



While I don't think current economic / financial conditions are rosy, the other side of a mean-reverting trade (i.e. when VIX jumps, it eventually moves down), that is priced 50% higher than current levels (i.e. a VIX of 32 vs the ~21 current level), and has only happened on two occasions since 1950 seems awfully intriguing.

Source: Yahoo Finance