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A Low VIX Does Not Mean High Complacency


Investors are misinterpreting the historically low VIX.

Along with the recent decline in the CBOE Volatility Index (INDEXCBOE:VIX), the put/call ratio has been trending lower, suggesting increased bullish sentiment.

But if you pull the curtain back, the put/call ratio actually shows a fairly high level of concern for a sharp market decline.

Before diving into a look the put/call situation, I have a quick comment on the CBOE Volatility Index (VIX), the better known, and more widely covered option gauge.

Reports of the VIX's death have been greatly exaggerated. 

Too many traders think the VIX is no longer a good reflection of market sentiment, or useful as a market gauge, because of its recent slide to historical lows near the 10% level. What people seem to be forgetting, however, is that the VIX is merely a statistic that measures the current volatility of the S&P 500 (INDEXSP:.INX) based on the value of its 30-day options. It is a snapshot of the current conditions.

The 20-day realized volatility of the S&P is just 5.8%, meaning you could argue that the VIX is actually overpriced and indicative of fear, not complacency.

Premiums on tradable volatility products (you can't trade the cash VIX) such as VIX futures indicate investors are actually betting on an increase in volatility over the next one to six months.

In trading, it's more important to see what people are actually doing rather than what they say.

Put/call ratios, which measure put option contracts traded, divided by calls, provide us with data on where money is actually being spent, offering deeper insights into sentiment and the internal structure of the market.

Put/call data can be sliced and diced in a variety of ways. Let's start with a broad long-term baseline.

The 10-year average put/call ratio for all exchanges is 0.72. This means on average there are 0.72 puts traded for every one call. For individual equities, the 10-year put/call is 0.65. For index and exchange traded funds, the ratio is 0.97. 
For perspective's sake, during steep declines, the equity-only reading moves up to the 2.0 - 3.0 range, and the index reading would climb to the 3.0 - 5.0 range.

Rarely do such readings persist for more than a few days. Even during the bleakest days of the financial crisis, the 10-day moving averages never climbed above 2.7 and 4.2, respectively. 

There are two main factors accounting for the differential.

Individuals tend to be more bullish, buying calls for speculation and selling them against long stock positions to create covered calls. Institutions like hedge funds tend to use index and ETF puts for portfolio protection and/or outright downside exposure. Recently the equity only put/call has dropped below the historical average, with the 20-day moving average currently at 0.53. 


People could be replacing stock positions with call options to reduce risk.

Also, the recent increase in merger and acquisition activity (and rumors about other deals in the pipeline) has caused a flurry of above-average call volume in individual stocks, causing a shift in the overall reading. Neither of these are inherent signs of a speculative frenzy or overly bullish sentiment.

On the other hand, the 20-day moving average put/call on index and ETFs is 1.01, which is actually above historical norm.

This suggests that despite the perceived "complacency" in the markets, professional money managers are still buying index-based puts for broad portfolio protection.

To get a clearer view of investor activity, we can look at the International Securities Exchange's ISEE Index. The ISEE Index is a call/put ratio (as opposed to put/call) that looks at only opening customer purchasing transactions. It filters out closing transactions and the short sales involved in covered calls. It also removes transactions conducted by broker/dealers and market maker accounts, which are typically used to facilitate customer orders.

The stripping out of the market-neutral trades helps reveal true customer sentiment. Again, we see a sharp dichotomy between individual stocks and the broad market.

Through the month of June, the equity-only ISEE has been trending higher, moving from the 160 level to 245 as an increasing number of calls versus puts have been purchased.  

For comparison's sake, a 245 ISEE reading (2.45 calls for every 1 put) translates to a 0.41 put/call reading.

By contrast, the ISEE on index products has trended from 75 at the beginning of the month down to 31 on Monday, prior to Tuesday's decline. This indicates an increase in demand for portfolio protection and/or speculation on a drop, even as stocks grinded to new all-time highs.

This brings us back to looking at what professional investors are actually doing rather than what uninformed people are saying. By peeling back what is actually happening in index options, specifically in the S&P 500, it's obvious that looking at the low nominal level of the VIX doesn't give the complete picture.

In a recent report, Credit Suisse (NYSE:CS) said its Fear Barometer has moved sharply higher in recent weeks.

This is a measure of a zero-cost collar in the S&P 500 using three-month options. It's calculated by selling a call option that is 10% out-of-the-money and using the proceeds to buy an equally priced put.

Right now, one would need to buy a put that is 35% out-of-the-money to find a put whose premium is low enough to match the call and create a zero-cost collar.

That is up from 25% just two months ago and the three-year average of 21%. This means people are paying up for out-of-the-money puts to brace for a sharp decline.

This is confirmed by both the term structure and skew in option pricing.

As mentioned, longer-dated VIX futures are trading at a healthy premium to the cash. The CBOE Skew Index (INDEXCBOE:SKEW) ,  which measures the curve of implied volatility across different strike prices, has also jumped to its highest level since the market sold off in early April.

Overall the option indicators suggest that investors may be starting to embrace the bull market, but are still feeling a need for protection and are willing to pay for it.

Twitter: @steve13smith

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No positions in stocks mentioned.

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