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The VIX According to a 20-Year-Old 'Seinfeld' Episode

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The foreshadowing from Cosmo Kramer and George Costanza is uncanny.

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So you have this group of investors who are perceived to know what they are doing. You have the pump-and-dumpers who convince the unsuspecting small investor to jump into the speculation. Then you crash, the perma bears come out of hibernation screaming about the end of the world and conspiracy theories, small investors puke, the market recovers and the pump-and-dumpers are back on the scene yet again obnoxiously reminding us "I told you not to sell." Sound familiar?

Today instead of measuring market sentiment at the coffee shop, the corner pub or front page of the Wall Street Journal investors are more and more coming to rely on the message of the VIX, the CBOE's volatility index. Perhaps there is no more widely cited and watched market indicator of sentiment than the VIX. Though constantly being quoted by pundits, strategists, and on financial networks and websites, there is maybe also no more widely misunderstood market indicator. In fact it's possible the obsession with recent extreme market volatility has ironically diminished the ability of the VIX to accurately gauge market sentiment.

The VIX reflects implied volatility (IV) premiums on various strikes of puts and calls in the current month and next month on the S&P 500 (^GSPC). Implied volatility isn't actual volatility it's the price component of an option over and above time value and intrinsic value. It therefore is supposed to reflect the market's demand for volatility insurance.

Investors draw the simple conclusion that if the VIX is elevated the demand for insurance is high therefore sentiment is risk averse and conversely if it is falling there is little demand for protection therefore investors are complacent about risk. However, I think this interpretation of simply relying on the outright level of the VIX as an indicator of market volatility expectations is misguided in certain conditions.

Friday the VIX broke the psychologically 15 level closing at 14.74, falling to the lowest level since the March 16 low of 13.66 when the S&P 500 was approaching the highs of the year. Many investors are looking on the surface at this apparent collapse in implied volatility premiums and conclude the market sentiment has become too complacent. However if you look under the hood at what the VIX is actually measuring the S&P 500 option activity tells a different story.

For this exercise we will focus on the put option side of the VIX since it is generally downside price action that generates spikes in IV. For the August options expiring next week as you might expect the near the money strikes between 1400 and 1375 saw much of the volume on Friday with a total of 26,857 contracts in aggregate and IV ranging from 11% at 1400 to 13% at 1375. The 1375 strike seeing 9,112 contracts traded was the highest near the money volume strike followed by the 1400 with 7,267 contracts. However with the VIX falling, the single largest volume strike price on the board was 1300 with 14,392 contracts at 24% IV seeing 58% more volume than the next nearest strike at 1375.

Granted the gross dollar amount invested is much lower but on an annualized basis you would be talking about a massive move in a short period of time to get paid. Is that a market that is complacent about risk lifting crash puts with a week left to expiration? This is not just a phenomenon from last Friday. It has been the case seemingly on every market downtick into month expirations that you see large activity and open interest in far-out-of-the-money puts. The market is not prone to paying out lottery tickets but they continue to be bought in size month after month.

The way I read the formula, the VIX is misleading in this environment of volatility paranoia because the way it's calculated does not effectively pick up extreme implied volatility (crash put) buying when it dominates activity. For one, the further out of the money the strike, the less contribution the option's IV goes into the VIX.

No positions in stocks mentioned.
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