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Stop watching the VIX

By: Market Intelligence Center
Posted: 7/14/2014 1:08:00 PM
Referenced Stocks:

In every industry, there are signs to indicate when the people involved have run out of useful things to do. In all industries, people congregate around the water cooler or the coffee maker, chit chat about TV shows, plan for the weekend, etc… There are times, however, when it doesn't do to be seen not working, so work must be done, whether there is work to do or not. For financial journalists, this is the point when many start drawing lines on charts in order to give the appearance, to readers, supervisors, and themselves, that they are, in fact, saying something about the market, which they are not.

Perhaps the most egregious example of the trend is the modern obsession with the VIX , a number that means far less than almost anyone is willing to admit. Here is why:

The further removed financial analysis is from the fundamentals, the less likely it is to provide an actual indication as to whether a stock is a good value. Index funds exist at one remove , and options exist at one remove . The VIX is an index of the relative (to what, no one knows) price of options, i.e., the premium, since that is the only part of the price that fluctuates based on market sentiment. This means that it exists at two removes .

The premium in an option fluctuates based on the sentiments of options market makers. If options market makers believe stocks will gyrate wildly in the future, the premiums will be high, and the VIX will be high. That, it turns out, is the most important thing to understand about the VIX, so I'll say it again: the value of the VIX, at any given time, is a forecast as to how volatile options market makers believe stocks will be in the coming months. Right now, the VIX is very low, compared to its historical levels.

You can also trade options on the VIX . To understand how supposed professionals could, when looking at VIX options, completely blow an analysis, it helps to understand that VIX options exist three removes from stock value. An example of such a blown analysis was published just today by Bloomberg . The article examines the ratio of VIX calls to VIX puts, which is four-to-one. That ratio, for those still keeping score, is a number four removes from actual stock values; it is a quadruple derivative , the likes of which your most sadistic calculus teacher would have been ashamed to throw at you.

I hope you are still with me because it's about to get weird. Because four-to-one VIX options traders placed bets that the VIX would go up, the analysts responsible for this article conclude that they are seeing a signal that there will be more volatile stocks ahead. These analysts have confused themselves and mistaken a fourth derivative for a third, a common mistake, but a fatal one (for their analysis). In fact, the VIX options traders in question have placed a contrarian bet against the prevailing forecast of options market makers, which is for lower stock volatility in the near future, not higher . That forecast, remember, is what the VIX measures; it is not what the put-call ratio on VIX options measures. Different things; different meanings.

When I look at technical analyses of stocks, I'm amazed that people waste time with something that is neither right nor wrong, but meaningless. When I look at analysis of VIX options, I weep for the future of my profession. Please don't ever make a move on the stock market because of something you have been told about VIX options. The chances of your having been told what you think you have been told are very, very low. The chance that it meant anything to begin with-well, that's almost non-existent. 

Julian Close has been a business writer since the first day of the twenty-first century, having written for PRA International and the United Nations Department of Peacekeeping. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. He became a stockbroker in 1993, but now works for Fresh Brewed Media and uses his powers only for good. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC .

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