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Volatility Trends

This complimentary article from Options Profits was originally published on February 6 at 10:24am EST. Don't risk missing over 40 options trade ideas every week and exclusive commentary from over 10 experts. Click here for more information and a 14-Day Free Trial.

Believe it or not Friday was the fourth most volatile day of the year so far. That is incredible considering Friday's total range was only 19 points. While we have had a lot of doubters, the speed at which we have crept up makes me far less suspect of this rally than some of the ones from September and October. In 23 trading days, the market has rallied about 100 points, a little more than four points a day. There are snails that move quicker.

There are traders that complain about volume and continued fears. And others that complain about the spread between the CBOE Volatility Index (VIX) and realized volatility, and they have a point. There is something a little creepy about a realized volatility of eight and a VIX of 19. That should cause alarm and has been raising red flags for some time.

I actually think we may have gotten the markets answer on Friday. Interestingly, I think the VIX and movement are finally starting to meet in a middle ground. If the SPX is moving 1% a day, that would be an annualized volatility of about 15.87%. If we add in 2% for market volatility risk premium that would peg the VIX at about 17.5-18%. On Friday the market moved 1.4%, the first time in the year (sans January 1) that the market outpaced option premiums. Considering the market outpaced the VIX on a rally and NOT on a sell off is, to me, a very bullish sign.

Moving on to the volatility complex, another bullish sign for the market is the VIX complex itself. Right now VIX futures are in some of the steepest contango we have seen. While contango is seen by the outside observer as ominous, to me it represents something simple, the term of fear. All futures are saying right now is fear in the immediate is not high because of longer-term uncertainty fear is higher in the out months. There are those that will point toward contango pointing toward dates and events, I could not disagree more.

The VIX futures are in contango about 80% of the time. If I walk down the street saying 'a car accident is about to happen' whenever I am outside, and then one time I say it and a car accident happens right in front of me, does this make me predictive? The answer is now, and I think the VIX futures are much the same way. Movement in contango and in structure is far more predictive than the VIX futures prices themselves. Just as VIX correlation is far more predictive than the VIX cash. Those looking for predictive pricing will find themselves a lot more luck looking at SPX options.

Moving on to the VIX ETPs, the steep contango is putting HUGE pressure on iPath S&P 500 VIX Short-Term Futures ETN (VXX) and to a lesser extent iPath S&P 500 Mid-term Futures ETN (VXZ). At this point I am starting to look at VXZ as a better short than VXX, although I am not quite there yet. I'll have something later today. We will hold VelocityShares Daily Inverse VIX Short Term ETN (XIV) until VIX futures start to flatten up.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.

Mark can be followed on Twitter at twitter.com/OptionPit.

At the time of publication, Mark Sebastian held positions in VIX and VXX.

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