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VIX Analysis: Frog and a Pot

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Up and up it goes, where it stops nobody knows! That was formerly the theme of the SPX, but now seems to be that of the CBOE Volatility Index (VIX). It continues its slow and steady rise higher, settling above 17 last week. This was on the heels of another slightly rough week for the S&P 500.

Yet, many traders will say, "So what?" The VIX at 17 is still below its long-term mean and mode." This is true, but also points to why simply looking at VIX levels on their own is so worthless. The last time it was over 17 for an extended period of time, the SPX was trading in the 1400s. A VIX of 17 with the SPX at 1625 implies movement of about 276 points up or down on an annualized basis, most of the time. A VIX of 17 against 1425 implies movement of 242 points. That is a lot less raw dollar movement despite the same IV. I think something is brewing. I am not sure what, but certainly something, despite the relatively tepid sell off the market has gotten.

The market, to me, can often act like a frog in a pot. If you throw a frog in a pot of hot water, the frog immediately jumps out because it can sense the change in temperature. If you put a frog in cool water, and then put it on a medium flame, the frog will boil to death because it is unable to sense the change in water temperature when it happens slowly.

I feel like many, smart people included, are trading like a frog in cold water. They assume all is well and that the market is the same as it was in 2012 and much of 2011. As Jim Cramer said last Tuesday on Mad Money, the VIX is slowly rallying with the market. The water temperature is changing, don't be a frog, jump out of the water and look around you.

So what does this mean? What is about to Change? For starters, markets where we get sell offs will separate the good traders from those who are lucky. I think we are setting up for a 2011 type event. Smart traders are preparing now and reviewing:

1. What put sales they want to take delivery on

2. Which income strategies can survive a big sell off

3. What long stocks they should dump

4. What long vega strategies make sense

5. How well hedged are their portfolios

Buy the dip has been so effective the last two years because there was so much cash left aside, lots of money in bonds, and belief in 'the Bernanke put.' Now that the Fed may change strategies, only two of three of those are in place. To make matters worse for stocks, as yields go higher in the 10- and 30-year bonds, the "TINA" trade (There Is No Alternative) goes away, that's also bearish for stocks.

Basically, the market is up BIG this year, and picking the top is not something any of us can do well. However, taking profits is something we can do well. Longs, it's time to take some chips off the table. Shorts, maybe it's time to increase the size of that wager. Vol sellers, the gig might be up for a short period of time. In the long run selling Vol is going to win, however, there will be piles of junk on that run, and this might not be the time to get caught out there.

Trade well and have a good week.

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

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

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


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