The $VIX, or the CBOE Volatility Index measures the market expectations of the near-term volatility conveyed by the S&P500 stock index option prices. Most investors look to this benchmark when talking about the amount of fear priced into the market. A more accurate way to describe this however is to say that the $VIX is the price paid for the current volatility in the market. That price can change based on how aggressive or complacent investors are.
Let me put that another way …. Is AAPL at $334.00 more expensive than SHZ at $10.24? Well, at first blush it looks that way because the absolute price is much higher. But the reality is that when you look at each company's near term earnings potential, you will draw a different conclusion.
So when was the market paying less for a unit of volatility – January 5th, 2011 with the $VIX at $17.02 or on December 17th, 2010 when the $VIX was at $16.11? You probably suspect that this is a loaded question …. the correct answer is on January 5th, 2011.
Let me tell you how I calculated the price being paid per unit of volatility in the market. First I take the SPY's daily close for its Average True Range ("ATR" using the common default parameter of 14 days) and then I divide this amount by the actual closing price for the SPY. This gets the ATR on a comparable basis when analyzing different time periods. For example, an ATR of $1.50 when the SPY price is $150 is quite different than having an ATR of $1.50 when the SPY price is $100. I'm trying to compare apples to apples. Next, I take a 10-day average of the resulting value to smooth out any day-to-day gyrations.
Then I take the $VIX closing price over the same time period and smooth out that data by taking a 10-day average. So now I have two values – one is the amount of actual price volatility in the market (as represented by the S&P 500 ETF's ATR), and the other is the price being paid for S&P volatility in the options market. Both series of data have been smoothed by creating a 10-day averaging.
If you then take the ATR figure and divide it by the $VIX data you get what price the market is actually paying per unit of actual volatility existing in the market … in stock terms, the price/earnings ratio of volatility.
Hope you are still awake …… here is the resulting data going back to the start of 2003 (that is the start to my $VIX data on eSignal) (click on chart to enlarge):
So what does the above chart tell us? It tells us that we are at the cheapest price being paid for volatility in my entire series of data. In simple terms, the market is getting 21.3 units of volatility for every unit of $VIX versus the average of 14.3 units over the period 2003-early 2011.
The only other periods in time close to this extreme level were those seen in early January 2004 and in early January 2010. As a side note it is interesting that the other two extremes in my series of data both occurred in the first part of the January month – says something about the optimism/froth in the market at the start of most New Year's.
If you believe that the price paid per unit of market volatility will correct towards the longer term average, the question remains … "what can happen to make the price paid per unit of volatility increase?" Well one of two things must happen (or a combination of the two actually), firstly, the price paid for option volatility as measured by the $VIX will need to rise. Or secondly, the actual volatility as measured by the ATR/price ratio will need to rise. Needless to say, that if the ATR rises in the market, option investors will begin demanding more for the volatility they are selling. Therefore, the actual result should be an increase in both ATR and the $VIX.
That is exactly what happened in January 2010, when the data approached current levels. After my volatility measurement peaked on January 11th 2010, the SPY corrected 7.7% over a period of 4 weeks. During that same time period, the SPY's ATR(14) went from $1.07 to $1.71. The current ATR for the SPY is $1.02 … an equivalent move in today's ATR would take it up to $1.63. The last time we had an ATR at that level was at the kick-off for the current market push in early December. The SPY was at the $122ish level at that time and the $VIX was around $19.00. In that January 2010 time period, the $VIX went from $17.55 to $26.51.
When you cut through all the analysis, what I am trying to say is that volatility is very cheap right now in the market place. And while prices can become even cheaper in the short term, I believe it is smart to begin buying volatility in the options market or via the volatility etf VXX. The other alternative of course is to raise cash in your equity portfolios.
I have done both … here was a nice buy signal on the VXX that I chatted about in real time on the chat site of T3Live earlier today.
Cheers …. Leaf_West