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The Volatility Trade

Posted By Barry Ritholtz On January 20, 2004 @ 12:18 pm In Finance | Comments Disabled

The long side of Volatility continues to be the wrong side of the trade. In our opinion, this condition cannot continue indefinitely.

Friday’s very strong sentiment numbers of 103.9 (versus a consensus of 97) combined with generally good earnings reports are pressuring the VIX further, and has lead to a continuing sell off of Vols. Last week, the VIX broke 15 intraday, and moved within a stone’s throw from the 52 week low of 14.66.

While the markets internals have remained extremely strong (see chart), we continue to see signs of complacency and speculative excess. This forces us into the uncomfortable position of being long – but not liking it.

Sentiment measures show a disproportionate number of Bears – an AAII survey last week was 66.29% Bullish, 23.60% Neutral, and a stunning 10.11% Bearish. People become Bullish after they buy equities, not before, which is why this Bullish reading is potentially dangerous. If everyone is already in equities, who is left to buy stocks?

If the nearly straight up Nasdaq rally continues unabated, look for a fresh run at new volatility lows over the next few weeks; This becomes more likely as earnings season winds down early next month. Is this a set up for the first test of the Bull market? With the indices extended, and a mad scramble to “get long,” it certainly is possible. By February, as we enter a more “catalyst free” period –such a test might occur.

In mid-October, we noted that a significant slide in the VIX was signaling an imminent short-term correction. That VIX move, from 23.26 to about 16.19, represented a volatility drop of over 30%. The Dow then lost 5% over the next 10 days, and the Nasdaq give up well over 100 points.

We noted a similar drop in VIX and QQV charts on December 18. That VIX move began from just over 18, and poked beneath 15.52 for a 15% drop – only half the prior signal. It was not enough to get us excited that massive complacency had set into the market. While there was some lack of fear, it was not at levels that reliably signaled an imminent reversal or sell off – especially with Seasonal factors working against a negative call.

This VIX move down (18.33-14.90) is now 18% and is already more than the December move. Any slide below 14 – a 25+% drop – would put us at levels that might be suggestive of a short-term reversal, and a modest, 7% or so correction. We will continue to monitor and advise.


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