History was made last week as the Nasdaq Composite Index rallied above 6K for the first time ever, but another milestone was the (near) historic drop in the Chicago Board Options Exchange Volatility Index, more commonly known as the VIX.
The VIX calculates the market’s expected 30-day volatility in real-time—based upon the price of a strip of short-term
S&P 500 Index options—and is often referred to as the “fear index” because a high reading often indicates that traders are nervous about the market. Conversely, a low volatility reading indicates a lower level of fear.
The Only Thing To Fear is Not Being in this Market?
On Monday, April 24, on the heels of results from the first round of the presidential elections in France, the VIX took a massive hit, falling almost 26%, its 4th largest one-day drop ever. As the week moved on and strong earnings numbers from the tech sector took the Nasdaq into record territory, the VIX continued to drop, finishing on Friday at 10.79, a settlement price not seen in over decade, and the third lowest monthly close since the indicator was created.
Not the threat of war with North Korea, nor the president’s new tax proposal, nor a potential government shutdown—all three of which reared their heads last week—could raise fear among traders, according to the VIX. But perhaps more telling than the current VIX level is the indicator’s trend over the last year, as shown in figure 1. Three times the VIX has anticipated macro events by spiking in price, yet following all three—Brexit, the U.S. election, and the French election—it dropped precipitously and each time to lower lows.
So, does the continued weakness in the VIX mean that traders can expect doldrums over the longer term? Not necessarily.
Lack of volatility is viewed by many as a net positive, but at the extremes it can indicate that too much complacency has come into the market. When there's no fear as to what the market may do, traders, investors, and even institutional participants can stray from, or “relax,” their risk management rules. This can lead to a frothy market environment, which can sometimes reverse course very quickly and rather violently.
It’s worth noting that the last time the VIX was at these levels was in the early days of what became the 2008 financial crisis. Within six-months of those lows, VIX more than tripled, ultimately recording the second highest reading ever in October of 2008.
If we look at the term structure of the VIX (figure 2)—which shows volatility expectations over time—we see that the indicator is higher in deferred-month contracts, with the January 2018 level around 17, which is above where the VIX was trading just before the French elections.
Of course, there’s no guarantee that the VIX will hit those levels. The current downtrend may very well continue, and despite short-term spikes along the way, may even hit all-time lows in the process. But traders may want to be on guard. If the next VIX spike doesn’t fully retrace—meaning the VIX doesn’t touch a fresh low when the dust settles after its next upward move—it might be a sign that a change in trend has begun and that fear is about to return to the market.
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