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Tuesday, July 14, 2009


volatility curve warning again

following up on this post of three weeks ago -- h/t to adam warner for noticing that the front-month forward contract for the VIX is trading at a premium level that has in the past indicated proximity to a market top. particularly interesting is how the premium is continuing to expand even as the S&P trades lower from the june high. this holds true of the 3-month forward as well, and a similar condition was a feature of the august 2008 top.

warner further comments on the coincidence of both the forward futures premium and the high implied volatility measured by the VIX as compared to the 20-day historical volatility, as analyzed by lawrence mcmillan.

Going back to 1993, The McMillan letter found 35 instances where the VIX vs. 20 day HV differential was 10 points or more. Obviously it has to resolve in some fashion, either HV picking up or IV falling, as the market will not overbid for options forever. McMillan found that in 31 of the 35 times, it resolved with HV perking up.

So fast forwarding to now, sounds like odds sure favor an increase in stock volatility.

But before you jump to conclusions that volatility = down market, consider this. When those 35 instances above resolved, there was little predictive ability as far as the market is concerned. He found the market lower 10 times, unch. 10 times, and higher 15 times.

Now he goes another step and relates HV to VIX futures, and VIX futures premiums and does find that when you get VIX premiums to HV high as above AND VIX blended futures at a premium, it provided a good market signal. Down. Problem is there are only five instancs thanks to the fact VIX futures are only 3 years old.

jason goepfert also comments on the shorter-term channel of the VIX.

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