VIX Officially Off Steroids

Posted January 9th, 2012 by Mark Sebastian in Trading & Analysis

VIX Officially Off Steroids

I have to admit, while I have been expecting the VIX to return to normalcy, I have been shocked at the speed at which it moved down. I have been writing for some time that I expect the VIX to fall down and fall down hard. We wrote about how in December we were expecting the VIX to dive based on how the futures were priced. Even so, I didn't think VIX would be threatening 20 by the first week of January.

So what has caused this massive drop in SPX option implied volatility? A massive drop in realized volatility. Letís remember, for the VIX to justify being over 30%, the S&P 500 needs to move about 1.9% a day in realized volatility. When was the last time we saw the SPX move that much? December 20th...over 2 weeks ago! In fact, looking at realized volatility over the last 10 days, the VIX could be dropping a lot lower next week:

Currently, SPX option IV (LiveVol's equivalent of the VIX) is trading at about a 6% premium to realized volatility (which is just over 12%, the white line). This is far greater than the historical assumption of 2% that most believe is priced into options. So what does this mean? One of 3 things:

1. The VIX is going to stay the same and realized volatility is going to uptick incrementally by 2-4%

2. The VIX is going to drop another 2-4%

3. The two will meet in the middle with SPX moving a little bit more and the VIX dropping.

For the VIX to really catch a rally, we would need to see the market move more than the index is currently pricing in for several days in a row. Right now, the index assumes the SPX will move about 1.25% a day, we would need the SPX to move more like 2% in order for us to make a big move over 25 anytime soon.

The Trade:

Based on what we stated above, Jan Futures trading at 23.05 needs to come in a little more, Feb futures have even farther to fall. A trade that might be really interesting would be to sell a SPX time spread and buy a VIX futures calendar of some sort. I also continue to think that owning VXX puts is a great play. I also love a long XIV position.

Charts and data from Livevol(R) Pro (http://www.livevol.com/)

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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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