By Surly Trader
One common misconception is that the widely followed volatility index, the VIX, will hit its peak when the market bottoms out. This is not usually the case. I like to think of the VIX as a measure of uncertainty. When bad news comes out, the VIX moves upward to indicate the future uncertainty of the market and the future uncertainty of just how pervasive that bad news is. It is almost always the case that the market will move downward when the VIX spikes or vice versa, but the relationship breaks down after time allows information to be disseminated and future risk to be assessed. In the case of the global financial crisis of 2008, the uncertainty about the magnitude of the crisis hit a max in November of 2008 whereas the market bottom was reached almost 3 1/2 months later in March of 2009. With the European risk flare of 2010, we saw the VIX uncertainty peak out in May with a market bottom hit in July:
VIX leads the charge, followed by VIX futures, then the S&P 500
I believe the fact that the VIX has made lower highs over the last few months is a good omen for volatility peaking out. We might see the VIX spike back up to its August peak as the market breaks down below its previous lows, but I doubt it will go much further. I am also happy to see that the 4th VIX futures contract, represented by “UX4″ above, is getting close to its 2010 highs. I believe that the next week or so will provide a good opportunity to get short volatility.
With regards to the massive peak in volatility reached in 2008, as I have stated in prior posts, I do not believe that we will witness a complete financial freeze up like we saw in 2008. This is an opinion and not a 99.9% confidence interval statement. If there is one thing that 2008 should have taught you as a trader: that you should leave your pride at the door. Always make sure that you can survive the worst case scenario either through purchasing protection or correct position sizing.
We are two months into a market cycle that really has provided little *new* bad news. A very ugly GDP number tomorrow or large confirmation of a double dip recession could change that significantly.
SurlyTrader is a portfolio manager at a large financial institution who specializes in trading derivatives.