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Tis the Season for VIX to Dip
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Tis the Season for VIX to Dip

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Tis the Season for VIX to Dip

What's with the market's fear gauge? Does the VIX need to be fixed?
That's the question many investors keep asking as the Chicago Board Options Exchange's Market Volatility Index (VIX) keeps ebbing in the face of the high anxiety that continues to grip global markets despite Thursday's respite.

Many investors think VIX should be increasing to reflect Europe's never-ending sovereign-debt crisis, which could spark a Lehman-style banking crisis that could decimate risk assets of all descriptions, including U.S. stocks.

VIX has recently receded back below 30, a level associated with fear of market maelstroms, and is currently below 25, a reading that suggests investors are confident about owning U.S. stocks. That contrasts with the decidedly "risk-off" behavior in the first three sessions of the week, when the broad market lost more than 1% a day and other risk assets—commodities and even gold—plunged.

The sub-30 VIX reading has some investors asking if VIX is broken. VIX is not broken, but its seemingly odd performance reflects powerful seasonal influences that can override – at least temporarily – strong fundamental concerns like the euro's possible demise.

Each year, VIX tends to peak in October, historically one of the stock market's most volatile months, and decline into December, historically one of the stock market's best months. The peaks and declines reflect the options market's anticipation that U.S. stocks typically start rising at the end of the year through early months of the new year until it's time again to "sell in May and go away." The seasonal pattern is holding true this year, despite the major issues.

"Volatility is arguably pricing in the holidays and seems to have decoupled from the market direction, but I don't think that lasts for long," says Jim Strugger, MKM Partners' derivatives strategist. He sees volatility spiking higher by mid-January.

J.C. Parets, a technical analyst, advised readers of his blog, allstarcharts.com, that VIX tends to reach an annual trough each December. "Last year's December low in the VIX made it five pre-Christmas bottoms in eight years. In 2009, VIX made its annual low on Christmas Eve. In 2004, the lows were put on Dec. 23. In 2004 and 2006, VIX bottomed out for the year on Dec. 18," Parets noted in a Tuesday post.

Attributing VIX's decline to seasonality may strike mathematically minded investors as specious, but there is a fundamental explanation for VIX's dip.

Put buying drives the price of volatility, as much as stock price. If investors are not buying puts to hedge against a stock decline in December, implied volatility—which is what VIX measures—tends to decline. If the stock market is seasonally strong, that deters the use of puts and calls to hedge, and implied volatility often declines. Pricing models read stock-trading activity as a sign that the future will be more like the past.

There is another possible explanation for VIX's seemingly strange reading. Many investors forget – or do not realize – that VIX only provides investors with a 30-day outlook on the U.S. stock market.
To get a real grasp of market sentiment beyond that short window requires looking at VIX options' trading patterns – not just VIX. Those trading patterns indicate that many investors expect the stock market could experience turbulent times in February.

For instance, in recent trading, investors positioned for VIX to surge as high as 47 in mid-February. If VIX spiked to 47, it would be because the stock market was spiraling downward.

One investor bought 30,000 February 37 VIX calls and sold the same number of February 47 VIX calls. The "spread" benefits if VIX surges to 47. Another investor bought 12,000 February 37.50 VIX calls and sold the same number of February 47.50 calls to express a similarly dark view of the market, which highlights how savvy investors handle VIX.

When VIX is low, savvy traders buy options that will increase in value if volatility spikes and the stock market declines. When VIX is high, they tend to buy options and stocks in anticipation of a rally. These contrarian investors like to say that they buy fear and sell confidence, which is a good strategy regardless of the season.





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