Is A Dropping VIX Masking Rising "Fear" In Most Other Asset Classes... And Does Hedge Fund SPY Pair-Hedging Explain The Market Melt Up?

Tyler Durden's picture

As the trading year draws to a close, and as the QE2 driven melt up shows little sign of relenting (or breaching the 1,200 S&P level), the ever popular VIX, or "fear index" continues to plumb new depths. For many this is a superficial sign of complacency and lack of risk of any major moves within stocks. However, as BNY's Nicholas Colas demonstrates, this is far from the truth as to what is happening below the surface. While highlighting the grind lower in the VIX, Colas observes that "the options market has been busy pricing in higher levels of perceived risk across a variety of asset classes, most notably investment grade bonds, silver, and emerging markets. In fact, of the 20 asset classes and industrial sectors for which we track risk pricing in the options market, 15 show heightened levels of investor concern for the upcoming 30 day period." How does Colas explain this remarkable divergence? "I am tempted to say that the sector IVs are actually better representatives of the market’s take on future volatility, and the lower expected volatility of the market as a whole comes from macro investors who think the next month will be smooth sailing. Conversely, those traders who use sector ETFs and their options to hedge specific single stock positions see a different and potentially more volatile story developing." We tend to agree with the second explanation, which also leads to another surprising conclusion... 

As most hedge funds now tend to hedge idiosyncratic risk using broad systemic hedges, most notably the SPY, which continues to be the most shorted (and "longed") hedge fund ETF, which, due to its being the most actively traded (or, some would say, churned) security by volume on US capital markets, in turn feeds the HFT relay to force robots to believe that due to daily pressure pushing the key market ETF higher or lower, the prevailing move in stocks should be higher (via forward feedback loops), when in fact hedge funds are shifting increasingly more bearish (short individual stocks, and net SPY buying) thereby explaining the constant move higher in stocks, and lower in teh VIX. Is hedge fund pair trade hedging (now that everyone is terrified of shorting individual stocks as pair trade hedges) with ETFs solely responsible for the daily move higher? We will likely not know with certainty until a forensic analysis of the market can be conducted after the next mega-crash, although recent observations of market moves lead us to believe that this could be one possible explanation. Then again with all modern-day feedback loops which have no formal start or end, in a market in which one wing-flipping butterfly can cause a market flash crash, who really knows...

We hope to revisit this most fascinating emerging feedback loop theory at a later date, but for now, here are Colas' complete observations on why anyone trading purely on a dropping VIX may be in for a rude awakening.

If the Boys Want to Fight, You’d Better Let Em

Only 36 shopping days left until Christmas, and 29 more trading days left in 2010. The S&P 500 is up some 7.5% year to date, and the most recent prices on the CBOE VIX Index come in just shy of 20. The options specialists at ConvergEx don’t like it when I call that the “Fear Index,” but since that’s the shorthand many on the Street use to describe the VIX we’ll use it here. Just for today – I promise. I will go back to “Expected price volatility/cost of insurance” with the next installment of these monthly assessments of the options market and risk pricing.

The bottom line on the VIX is that both in terms of its absolute level and general trend, there just doesn’t seem to be any real fear in the U.S. equity markets. If the market is metaphorically a gathering place of buyers and sellers, then the current environment resembles a Seattle coffee shop. A quiet murmuring crowd. The low hiss of the milk foamer. Maybe someone playing Jewel covers on an acoustic guitar in the corner. The VIX is below 20 and has been moving lower in a calm collected manner since May. Over the last month, for example, the Fear Index (sorry, options guys) has come in from 20.6 to less than 19 yesterday.

Other parts of the options market, however, look more like a roadside bar on Hells Angels initiation night. The VIX is down over the last month, yes, but just look at our accompanying graph with 19 other industrial sectors and asset classes. That exhibit shows what is essentially the “VIX of…” these groups. You will notice that expected volatility in large cap U.S. stocks (S&P 500) is in the distinct minority when it comes to declining levels of fear. Here are a few examples of where the options market clearly sees more reason for near term concern:

Among asset classes outside of stocks, the options market has seen incremental concern in Investment Grade Bonds, Silver, Emerging Markets, Junk Bonds, International Stocks, and Gold. You might at this point ask how we calculate these changes. The answer is that the proliferation of Exchange Traded Funds tracking diverse asset classes has led to an active listed options market for these securities and the asset types they track. From there you simply calculate the Implied Volatility for the options associated with the ETF in question. We use as our source for the data presented here.

Most of the sectors within the S&P 500 are seeing higher levels of expected near term volatility, even though the VIX itself is down. This includes Energy, Consumer Staples, Materials, Tech, Health Care and Consumer Discretionary. When you think about it, this is an oddball observation. How can the expected volatility of the index decline if the individual sector IVs are increasing? Low price correlations might explain the difference, except correlations are quite high at the moment. I am tempted to say that the sector IVs are actually better  representatives of the market’s take on future volatility, and the lower expected volatility of the market as a whole comes from macro investors who think the next month will be smooth sailing. Conversely, those traders who use sector ETFs and their options to hedge specific single stock positions see a different and potentially more volatile story developing.

The last point I would like to make is on Gold. There has been some concern of late that the yellow metal has topped out for the year and perhaps for good. Looking at the data from the options market, the “Gold VIX” doesn’t show either extreme complacency or extreme worry. It is exactly in the middle of its historical range of 15-25, with a current reading of 20. Maybe that puts Gold in the coffee shop rather than the roadside bar, but it does seem that the risk pricing in the options market does not support any overly positive or negative call.

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doolittlegeorge's picture

has Ben Bernanke "destroyed the Treasury complex in order to save it?"  What I wouldn't give to be a fly on the wall of Tim Geithner's office right now.  Which makes me it me or is George Bush still President?  I thought "the other guy won"?

DosZap's picture

Well, our beloved GW said twice in an interview IF asked he would have given his support for BHObumma over McCain, and that tells me volumes.

There could not be two more (Different personnas),than GW & Sotero.

To say that in an interview, is the sort of thing that gets conspiracy buffs juices flowing, at least to me.

Id fight Gandhi's picture

Tired of hearing the cliches of sell in may and go away. Septerb, October are the worst month, if January is down the whole year is down, and markets have a Santa claus rally.

Everything is turned upside down. How can people expect this broken market to be bid up when you have unemployment so high, European countries falling apart and a depressed real estate market?

Tomorrow well have an amazing GDP bte and the Asian and euro markets that are diving now won't matter. Right?

monopoly's picture

It is surreal how this market just continues higher with very little respite. We move down for a day or two and then start a relentless trek upward again. Shorting for the most part has been a poor bet, yet tough to go long if you read and see more than the mainstream media whitewash. This will end at some point, and to make it worse for us bears, who are afraid to short and have been for months, it will start on a Sunday night as Tokyo opens for business and our spoos are limit down.

But if gold drops 100 or more, I will just add to it. Most of this planet is a powder keg on a short fuse. May be a while, but when it blows it will be noticed.

banksterhater's picture

It's like shooting fish in a barrel for the PDs to burn the shorts, the entire rally is based on closing it down and opening it up 40-60 on the Dow premarket, that's the entire scam.

If ur lucky, you'll scalp a short intrday, but holding overnight is suicide, that's their design.

AUD's picture

What do you mean 'melt up'?

The ASX at least will be down 2 days in a row. I also think it will be down on the month. Just another sideways move like the last 13 months.

This Fed POMO you speak of seems half hearted to me.

revenue_anticipation_believer's picture

those categories that, in fact, were biggest movers showed the high speculative premium....and indeed were roughly the expectable categories that QE2 might/might not cause

price inflation...

the question remains speculative, WILL the next 30 days prove that QE2 was 'just-in-time' for a 'break even 0-2%' offset to pre-existing massive deflationary permanet consumer DEMAND DESTRUCTION...that 'oversupply' will overcome max'd out credit cards and shop til you drop/frugality... which case, the speculative unsureness/premium/VIX
is minimally prudent, not enought, even..

banksterhater's picture

QEII isn't the affect as before. The top income consumers are spending which is BUTTrussed by the Squatters, aided by discounting and early holiday promos, but it is what it is, voodoo sustainability especially with foreclosure halts (which has ALWAYS happened during the holidays)

Common_Cents22's picture

is there an oppty in the VIX or will it continue to be irrational longer than a trader can remain solvent?

ZeroPower's picture

Premiums are cheap so you might as well hedge with options ( =your opportunity)

geminiRX's picture

Chinese markets getting pounded right now?

Terra-Firma's picture

Perhaps the market melt-up is a function of total gain at the margin. If the Fed spends $10 to boost a stock $1 dollar and the total net wealth created is  $50 because there are 50 shares in total; the $10 investment has generated a five fold leverage. This is how the FED thinks and operates. Of course this only works when there aren't any serious sellers. I've never seen what happens then. Has anyone? This is all rather new as Bernanke admits.

Mercury's picture

I'm kind of a VXO man myself which is the old VIX and is basically computed from at-the-money put and call prices on the OEX (S&P 100).  And yes the VXO is way down too.  The point is, if VXO is down, protection against big index moves is cheap by definition and I think that would be a bargain here.

Although VXO flat-lined for a while around these levels during the super-happy-fun-times circa 2006 it seems ridiculous that it would stay down here for long given the train and given the track: Ireland/Europe, TSA holiday airport tension, looming Congressional battles, QE2, some tiff with China, (update: Korea!), another flash crash...just so many ways to wipe out.

In any case, trying to hedge anything with ETFs is dicey I think, especially when TSHTF.  I'd stick with options.


Milton Waddams's picture

Somebody please tell Colas that VIX has little insight into complacency and fear.

Further, VIX is pushing against the low end of the late nineties - early oughts equity bubble and crash dynamic.

If The Bernanks Central Bank bubble does not work as well as Greenspan's Housing Bubble (remember when he bottom ticked interest rates as he encouraged people to take out adjustable rate mortgages?) look for VIX to find a new, permanent range between 50 and 100.

ZeroPower's picture

Well, as much as the VIX shouldn't be the sole thing you base fear or complacency on, by definition it does in a way calculate investor's sentiment for protecting their bets (and thus, a fear index if it's especially at really high levels like in May).

I agree with your thoughts on Greenspan - but historically the VIX has always been much lower than the range you state for the upcoming new normal. What do you state as the factor for such high future premiums? Note the level of the SPY and the VIX are not always a concrete inverse correlation..

greenewave's picture

There is a very serious possibility we have a BANK RUN December 7th. Please watch and share this video with the people you care about (


This is really scary guys, people are already talking about it and it has spread from France to the UK and now coming to the United States.

ThreeTrees's picture

Niall Ferguson: Empires on the Edge of Chaos


Every now and then I log on to specifically to check for more talks given by this man.  Today I hit paydirt and I haven't noticed this video posted here.  As Zerohedgers, I feel you peeps will dig this talk:  He talks about power curves, gives historical comparison and yes, he is referring directly to the USA.

papaswamp's picture

I think so many bears have gotten out of equities that the market and thus the vix have very muted response to what is happening in the real world. Though Wall Street disconnected from main street a long time ago.

sumo's picture

VIX put premium = 1/QE


spanish inquisition's picture

Thinking this also, heard a report that raw farmland in midwest is ticking up. Looks like the money on the sidelines is starting to check out.

Bartanist's picture

Maybe there is no fear in the market because:

a) Hedge funds are deleveraging or disappearing and placing fewer stock market casino bets.

b) The trades made by real people are now so massively dwarfed by the robotrading HFT trades that they have virtually no impact on VIX

c) The HFT robotraders are getting more efficient at smoothing price and trades

d) Maybe in this modern market of ETF casino chips, VIX is measuring the wrong thing

e) Maybe the dumb money that generally is subject to fear and greed has left the market forever. No trust, no mas.