VIX hits 5 Year Low

by Jay Pestrichelli on March 13th, 2012

I know, two days back to back about the VIX, but we feel understanding the VIX can be an integral part for the mid to advanced skilled hedger.

The last time the VIX saw a 13 handle like it did this morning (13.99 at the open) was June 2007. As you may recall at that time, the S&P was trading in the low to mid 1500’s and market was on its run up to the all time highs in October 2007. The VIX itself, however, was moving up from its lows of below 10 in December 2006. Yes, the VIX was below 10 in December 2006.

Many traders have talked about how the VIX can be a hedge. I’ve seen TV commentators discuss how spreads or even on calls on the VIX can provide protection for wild swings. And while this is true, it can be expensive and timing has to be perfect. We’ve tested these strategies many times over to find a repeatable and disciplined way of defining a strategy and it is difficult.

All of the models we’ve developed require some level of timing and being able to digest lots of and lots of losses. It can be done, its just something that we feel the average investor won't master without feeling some pain.

So why do we follow the VIX, then? See “What Does a Low VIX Mean?” from yesterday’s post. Essentially we say that the VIX helps us determine which hedging strategy to use to be most effective with our hedging dollars.

What should we expect?

The market usually looks for a reversion to the mean. In other words, extremes usually are met with resistance and a VIX at 14 will find the natural inclination to go higher back towards its average. However, we know extremes do occur all the time so a trend can continue.

Let's remember where the VIX comes from. It is a derivative of a derivative. Meaning it is the Implied Volatility of the Options on the S&P 500. This means that is latter half of cause and effect. The VIX doesn’t drive the market. Rather, it is, itself, driven by the market. I mean to say that the S&P is the cause and VIX is the effect.

Looking at the VIX for a hint of what to expect next is like reading newspaper to predict the news. Yes, you can find historical events to follow, but the news itself is what drives the stories. Not the other way around.

So we reiterate, what was said in yesterday’s blog. Use the VIX for what it is, a way to determine if options are expensive or not. Stick with that and you wont find yourself in a trade you hate 5 minutes after it executes.

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