August Option Advisor: VIX at Critical Juncture

The following is a reprint of the market commentary from the August edition of the Option Advisor, published on July 22. Prices and the chart are as of the close on July 22. For more information or to subscribe to the Option Advisor, click here.

As you can see from the accompanying chart, the 200-day moving average of the CBOE Volatility Index (VIX - 24.63) has been quite significant over the years. This should be somewhat surprising to many students of market technicals, as moving averages are supposed to be a tool for gaining insight into the price movement of instruments such as equities that routinely display "price trends," whereby price movement in a particular direction begets more price movement in that direction. But volatility is said to be a "mean reverting" instrument, in which case pronounced price movement in a particular direction is most likely to beget movement in the opposite direction.

Yet the breakout by the VIX above its 200-day moving average in September 2008 was followed by the huge fourth-quarter 2008 VIX spike as the market plunged; the breakdown below the VIX 200-day in March/April 2009 was followed by a 50% decline in the VIX over the following six months during which the market rallied sharply off its March lows; and the VIX move back above its 200-day on May 4, 2010 was followed two days later by the "flash crash" and a quick double in VIX levels.

I believe the VIX is now at a critical juncture. Pullbacks since the May "VIX fever" subsided have all been contained at the 200-day moving average. In fact, the VIX has been supported just above this level for each of the past three trading sessions. VIX pullbacks are almost always associated with stock market rallies so it is not surprising that the rallies since May have disappointed, as they have ground to a halt each time the VIX has held at 200-day support. And this connection is more than coincidental, as "protection buyers" look to purchase put options or VIX calls or VIX futures when the VIX is perceived as "cheap," and these actions create short-selling activity that depresses stock prices.

In fact, there are those who say that the action in the VIX futures can be predictive of future VIX levels, and this VIX futures action right now has bearish implications. In a recent note, Larry McMillan points out: "These (VIX futures) premiums are large in the front end, and historically huge in later months. In general, this is a bearish sign, although there have been some times in the past when this was not the case." I would note, however, that the activity in these VIX futures "out months" as measured by their total open interest is rather small, which to some extent damages the credibility of the futures premiums as a smart money indicator.

So what does this all mean for you as a stock market investor and options trader?

I think it is pretty clear that the action in the VIX is going to resolve itself one way or the other before very long. If the 200-day moving average continues to hold (and if the VIX futures traders are correct) then we should see another VIX spike higher accompanied by a weak market. But if the VIX 200-day were to break as it did in early 2009, we should be in for yet another surprising rally at a time when investors are least expecting it. As our Ryan Detrick said in the July 17 edition of our Monday Morning Outlook: "There have been net redemptions for three straight years from equity-based mutual funds. The last time we saw three straight years similar to now was 1979-1981. Looking back, not a bad time to be accumulating stocks ahead of one of the greatest bull markets ever."

My advice is to retain long exposure but continue to hedge so you can stay whole during periods of market turbulence. While put premiums are not historically cheap, they have been a lot more expensive than they are these days. My favored options strategies right now are those that can profit from volatility regardless of price direction, in particular, straddles, strangles, and "paired trades" that play calls on one stock against puts on another.

One final note - "Volatility" is the theme of our soon-to-be published issue #6 of SENTIMENT magazine. Click here to view the current issue online or to sign up to have SENTIMENT delivered directly to your mail box.

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