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VIX Says, "Fear Me"

The VIX is not running up on increasing market volatility or heightened hedging activity. Since the volatility index is based on the expected volatility priced into S&P 500 Index options, it is a forward-looking indicator of market volatility. Why is the "fear gauge" telling investors to expect a substantial increase in volatility? The answer: RISK.
Author:

The

CBOE Volatility Index

I:VIX

is sometimes called the market's "fear gauge" because it rallies during times of panic and confusion on Wall Street. Since the index is based off

S&P 500 Index

(SPX)

options prices, it moves higher when portfolio protection is in high demand and investors are snapping up put options on the S&P 500. Today, the volatility index is in the midst of a seven-day, 17.1% run higher. It's interesting because overall put volume in the S&P 500 Index has been declining and there is very little evidence of increasing demand for portfolio protection. VIX is rising in a period of low volatility and diminishing hedging activity. It's a signal to investors that higher levels of market volatility are on the way.

In contrast to the VIX, actual volatility has been falling since the month of June. If you look at the average daily moves in the S&P 500 Index, the month of October was the second least volatile month of the year. The index experienced average daily moves of less than six points. The most volatile month was May, when the average daily move in the S&P 500 was more than 18 points. The trend in the second half of 2010 has been falling volatility.

Volatility has been falling along with the dollar. Thanks to the Federal Reserve's efforts to stimulate the economy through "Quantitative Easing", the dollar has not fared so well. Why? Because of low interest rates. The Fed is expected to announce its second round of the quantitative easing, or QE2, today. The Federal Reserve is hoping to stimulate through the purchase of Treasury bonds. By supporting higher bond prices, the Fed is keeping yields (interest rates) low and hoping to stimulate economic activity. These low yields in the US are making the dollar less interesting vis-à-vis other currencies. The

PowerShares Bullish Dollar Fund

(UUP) - Get Invesco DB US Dollar Index Bullish Fund Report

, which tracks the buck against a basket of other major currencies, is four-month bearish funk.

Volatility is falling along with the dollar due low interest rates motivated by the Fed's QE. While low interest rates drive down the dollar by making it less interesting relative to other currencies, they also serve as a floor under the equity market. Money is seeking higher returns in riskier assets like stocks. After a turbulent spring, volatility has been falling in recent months. The actual volatility (as measured by statistical volatility over the past 20 days) of the S&P 500 Index is less than 10%.

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VIX, the market's fear gauge, is approaching 22% and therefore 120% over the market's actual volatility. Such a huge divergence between VIX (22) and actual volatility (10) is very unusual! Some market watchers think that the relatively high VIX is due to increased hedging activity and higher demand for SPX puts. Not so. Volume in the S&P 500 Index has been exceptionally light during the recent run-up in the VIX. There's no evidence of increased hedging activity in the index options trading pits!

If it's not increasing market volatility or heightened hedging activity, what is sending the VIX higher? Since the volatility index is based on the expected volatility priced into S&P 500 Index options, it is a forward-looking indicator of market volatility. Why is the "fear gauge" telling investors to expect a substantial increase in volatility? The answer: RISK.

The risk is that the Fed's QE2 strategy falls flat on its face. After all, success depends a lot on bond traders (China, hedge funds, and other big holders of US bonds.) If they collectively decide it's time to sell Treasurys, the impact for financial markets is enormous. Namely, bond prices fall, and interest rates go up. The dollar reverses direction. Money exits riskier assets and, like the VIX, actual levels of stock market volatility begin to tick higher.

See you Friday!

At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.

Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.

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