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Best of Intentions

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Do you ever have one of those days where you know exactly what you want to accomplish and just as you sit down to get started, something comes up that requires you to change your focus? That's what happened to me this afternoon as I sat down to write this column. I originally was going to address a really interesting email from one of my newer readers, someone who is an experienced trader, but new to options trading. He asked a really insightful question about the pros and cons of option trading vs. stock trading, and I was really looking forward to sinking my teeth into the topic. Alas, something more urgent came up (at least in my opinion), so with apologies to Jerry, I'm going to postpone that topic until next week and spend the next couple pages talking about one of my favorite topics (at least you'd think that to see how many articles I've written on the topic over the years), the VIX.

We're not going to talk about any of the basics today. I've covered that more times than I care to remember. Readers that are new to this column or just want to get more basic information on the VIX can check out the background articles I wrote back in 2001.

Measuring the Mood of the Markets
VIX Details for the Masochist

For a quick peek at some of my recent musings on the VIX, you might also want to catch up on these articles, as it outlines some of my thinking on the potential for a change in the behavior of the VIX.

Volatility Overload?
Fixated On The VIX

Alright, so what was so all-fired important that I needed to torture you with another treatise on what's going on with the VIX? Believe it or not, my inspiration came for a short piece on the VIX on CNBC this afternoon. It has gotten to the point where I rarely pay attention to what's on that channel, with the notable exception of any time Art Cashin is speaking, as I think he is one of the wisest people in our business to regularly get in front of the microphone. But there is another regular segment that I try to follow, and that is Jim Jubak's weekly piece. He frequently does a great job of taking a seemingly complex concept and breaking it down into terms that make sense to the average trader. Today the topic of his talk was that of the VIX, and I was stunned with the simplistic manner in which he presented it. Sure he made it understandable to all in his easy conversational style, but I feel he did a great disservice to the investing/trading community.

Essentially, he described how fear drives the VIX up and complacency drives the VIX down, with readings above 30 indicating excessive fear and readings below 20 indicating excessive complacency. Since the VIX is now above 35, Mr. Jubak drew the conclusion for his viewers, that the VIX is indicating an excess of fear, as the markets prepare for a powerful rally should the right catalyst appear.

You see, the missing component in his discussion is the very real development that the range of the VIX is changing, a topic that we've been actively discussing here for the past several months. Linda Piazza actually got me looking in the right direction with her frequent comments about the action of the VIX in relation to its 200-dma. Since all of the historical data on the VIX indicates that the floor for this measure of market volatility is tightly connected to the movement of the 200-dma. I recently postulated that a practical floor for the VIX appears to be about 18% below the level of the 200-dma, based on the historical data. Well, with the 200-dma at 34.54, the practical floor for the VIX is just above 28 (34.54 x 82% = 28.32). Look at the chart of the VIX below, and I think you'll see what I'm getting at, with respect to the rising range. The VIX hasn't been below 25 (historically the middle of its normal range) in over 8 months, and it shows no signs of going that low anytime soon.

Weekly Chart of the VIX

The reason this is significant is that if we as traders are watching the VIX for typical buy and sell signals at the historically normal points, we're going to be waiting a long time. We have to adjust our expectations about what the VIX is trying to tell us by attempting to realign the rising range with the extremes of sentiment (panic and complacency). The VIX still performs this function, albeit in a different range. Linda and I have been discussing (via email and in the Market Monitor) the implications of the descending trendline on the VIX that has been capping any upside move in the index since late January. That trendline (as shown on the chart above) is still very much in effect, continuing to press the VIX ever lower.

What is strange about this action is that this consistent downward pressure in the VIX is coming at the same time that the broad market is continuing to post lower highs. This relationship can't hold indefinitely, and we are either going to see a powerful rally in the broad markets or something is going to cause the VIX to explode through that descending trendline (as the market falls). Based on the chart below, I think it is the latter development that will actually occur.

Split Chart of OEX vs. the VIX

You see, throughout the August-October timeframe, each time the OEX fell below the $430 level, the VIX responded with its own move above 40. And on the way back up (for the market), the VIX couldn't get back under 40 until the OEX was solidly above the $430 level. But that relationship has begun to change and change significantly in the past couple weeks. Look how the latest rally attempt stopped just above the $430 level before reversing back down, while the VIX is continuing to languish. As of today's close, the OEX is at $418, and the VIX is "only" 37!

This is important because it tells us one of two things. One, the market "knows" that the worst case scenario for Iraq and the economy has already been factored in and we aren't going substantially lower, which is reflected in a lower reading in the "fear index". The second possibility is that market participants "Think" the worst has been factored in and are thus positioning themselves for the 'inevitable' rally when the Iraq uncertainty is removed. Guess what? That is a pretty good definition of complacency and I think an apt description of what we've been seeing in the market recently. Selloffs have little conviction or follow-through with willing buyers lurking just below broken support levels. And when we do get a decent selloff, it doesn't result in a sharp increase in the VIX like it has in the recent past.

What I see in that second chart is a pattern of behavior that is DIVERGING from what was seen during the August-October timeframe. Lower prices on the OEX are not resulting in higher values for the VIX. I don't know about you, but that sounds like complacency to me. The reason I've gone through all of this in such excruciating detail is that clarity and understanding are paramount, especially in the crazy market conditions we've been subjected to over the past month. I don't claim to have all the answers, but based on the evidence, I sure don't think the market is telling us that there is an overabundance of fear in the market.

It's all about defining the right levels as "high" or "low". I think Mr. Jubak did his viewers a great disservice this afternoon by basing his definitions of "high" and "low" on outdated thresholds that are no longer relevant in the current market. The risk is that traders/investors would view the current market as attractive from the long side, just based on the 'elevated' VIX. But we know better don't we? At best, the VIX is near the middle of its new, elevated range, and I take great satisfaction in knowing that while you don't necessarily have all the answers, at least you have enough information to make informed decisions about what the VIX is indicating about the relative level of fear among investors and the level of risk in the market.

Questions are always welcome!


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