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Understanding the VIX



The above chart is pretty self-explanatory: the VIX index (a weighted composite of implied volatilities of various index options) at these levels in the past has led to a market decline. The reasoning we have explained before: as investors get complacent they sell options, either trying to earn some premium (thinking stocks won't move much) or through "lifting" hedges (selling out puts they no longer believe they need). Complacency is the opposite of fear and is normally associated with "over-investment".

The story is more complicated than this however. The skew is still not overly flat and longer term options have not come down as much as options out to the end of the year. This indicates some "concern" exists after the elections and into 2005 and 2006. Perhaps this is warranted as more debt from corporations is due later in 2005 and 2006; that process may prove painful if rates rise. Again, the equity markets are inextricably linked to the U.S. bond market and the dollar.

A last observation is that option prices are still higher than actual volatilities: the spread between option prices and actual volatilities are about average. Actual SPX volatilities are near historic lows, trading between 9% and 11%.

The structure of the options market is indicating two things: current high complacency in the short run and in the long run, any declines in the market are unlikely to be a crash scenario (exogenous of a major macro event or a significant decline in the bond markets) like 1987. Rather, declines will be more muted and difficult to maneuver.

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