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Options Traders May Be Too Bullish for Their Own Good


The path of least resistance is for short-term event volatility to rise.

The VIX closed at 26.36 yesterday, down 15.4% from the Monday close of 31.17. Yesterday's close was at the lowest level seen since the 25.66 close on September 12, 2008 -- the last trading day before Lehman Brothers' bankruptcy was announced.

According to the classic 10-day simple moving average measure -- which has the VIX currently sitting 11.7% below that level -- the VIX is now in an "oversold" position according to both TradingMarkets' 5% rule and the more stringent 10% threshold used by other traders.

From a volatility-term-structure perspective, the VIX is also oversold. Notably, the VIX:VXV ratio -- which compares 30-day volatility of SPX options to 93-day volatility (using the VXV index) -- closed at 0.896 today.

In the chart below, you can see that when this ratio closes at 0.92 or below, the bears tend to have an upper hand for at least several weeks. When the ratio drops below 0.90, as was the case yesterday, the odds shift even more favorably in the direction of the bears.

Click to enlarge.

In brief, the low current levels in the VIX:VXV ratio suggest that options traders are too bullish and complacent in their 30-day outlook (event volatility) relative to their 93-day outlook (structural volatility.)

While these 2 volatility measures can be brought back into line by lowering estimates of long-term structural volatility, the path of least resistance is for short-term event volatility to rise.

This means the odds favor that the VIX will move in the direction of the VXV, which closed at 29.41 yesterday. Of course rising volatility tends to favor the bears at the expense of the bulls. Even with yesterday's exceptionally strong close, longs should consider taking profits and/or initiating short positions.
No positions in stocks mentioned.

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