The VIX Must Fall and is about to Officially Be Overpriced

Posted August 17th, 2011 by Mark Sebastian in Trading & Analysis

The VIX Must Fall and is about to Officially Be Overpriced

What does an overpriced VIX really mean? If one looks at historical volatility relative to implied volatility, the VIX is almost always to high. Traditionally itís considered 2-3% over priced. This is because, in order for the VIX to be fairly priced it would have to move more than 2% (actually 32.85/ (sqrt 252)). Right now though the SPX seems to be slowing down, not speeding up:

The SPX keeps having a tighter and tighter range today, moving more like 1%, which would put the VIX closer to 16% than 32%. This is part of the reason that we are seeing the VIX have lower highs and lower lows (a sign it is overpriced):

Today, when the SPX was down almost as much today as it was up yesterday, the VIX was only picking up about half of what it gave up yesterday. You'll recall I spoke about the VIX ramping up on CNBC (look at our front page to watch); if they had me back on today (I'll be on sometime soon, just not today), I would talk about how I see the VIX ramping back down. Do I think there is still a decent chance for a trip to 40...yes, but I do not think itís a sure thing anymore.

Another thing to notice is this is the first day where the VIX and the volatility of VIX options have moved in opposite directions. Today IV of VIX options was down, not up, and skew was flattened as well. This is yet another sign that expectations of a major pop in IV is considered increasingly less likely.

This presents us with many opportunities in VIX options, VIX etn's and SPX. I am, at this point, bullish in the short term. I would point out that there are some very juicy IV's for those with the guts to sell premium here, especially relative to the movement. That said, make sure to insure. VIX IV is high, but with steepened skew, call spreads to not seem that expensive. The same holds true in SPX, if an outright put is too much, what about a put spread?

For those that want to trade 'income' spreads, take a look at condors, they seem to make the most sense.

Images courtesy of LiveVol.

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Mark Sebastian is the Director of Eduction for Option Pit, and a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange. He has been published in nationally on Yahoo Finance, quoted in the Wall Street Journal is a featured contributor for TheStreet.com. He also writes regularly for SFO, and OptionsZone, and is the managing editor for Expiring Monthly: The Option Traders Journal.

To learn more about Option Pit and its mentoring services, please visit OptionPit.com

About Mark Sebastian

Mark Sebastian is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange. Along with his role directing the path of education for Option Pit, Mark is currently the director of risk for a private hedge fund. He writes a daily blog, the Option Pit blog, formerly Option911. Sebastian has been published nationally on Yahoo Finance, Google finance, Financial Times Alphaville and is a featured contributor for TheStreet.com. He is also published regularly at SFO, the Options Insider, and is one of the Co-Hosts of The Option Block Podcast, a featured Podcast from Options Insider Radio. Mark is the managing editor for Expiring Monthly: The Option Traders Journal. Sebastian has a Bachelor's in Science from Villanova University. To learn more about Option Pit and their mentoring services, please visit: http://www.optionpit.com

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