STRANGE BEHAVIOR IN THE VIX -- VOLATILITY REMAINS RELATIVELY HIGH -- PUT/CALL RATIO STAYS SUBDUED -- SMOOTHING A PRICE SERIES

VIX LAGS THE S&P 500 ... Today's Market Message was written by Arthur Hill. - Editor

The S&P 500 Volatility Index ($VIX) measures the implied volatility for a basket of S&P 500 options, both puts and calls. John Murphy pointed out a rising VIX on Monday as it broke the 50-day moving average and triggered a buy signal on the PnF Chart. Increasing volatility is usually associated with rising fear, which is bearish for stocks. Decreasing volatility, on the other hand, shows increasing confidence, which is bullish for stocks. Volatility is also a measure of risk. The higher the volatility, the riskier a security. Chart 1 shows the S&P 500 Volatility Index ($VIX) working its way higher over the last five weeks. This rise corresponds with a decline in the S&P 500 over the same timeframe. By and large, the inverse relationship between the VIX and SPX remains intact.

Chart 1

Despite a clear inverse relationship, one can't help but notice that the VIX is not keeping pace with the S&P 500. While the S&P 500 moved below its November low, the VIX never even came close to its November high. A corresponding move in the VIX would have carried it above the November high. In fact, the VIX is even below its January high. What is this telling us about option volatility, fear and risk? Based on lower VIX readings, the implied volatilities are much lower now than they were in October and November. Fear levels, and by extension, risk, were much higher in Oct-Nov. Despite a move to new lows for the S&P 500, there is less fear in the market now than there was in Oct-Nov. This is potentially positive, but the VIX is still rising over the last five weeks and this is currently bearish for stocks. At the very least, a move below the late February low is needed to reverse the uptrend in volatility. For reference, Chart 2 shows the Nasdaq Volatility Index ($VXN) and chart 3 shows the new S&P 500 VIX Futures ETN (VXX).

Chart 2

Chart 3

VOLATILITY STILL RELATIVELY HIGH... Even though the S&P 500 Volatility Index is below its Oct-Nov levels, it is still above the pre-crisis levels I showed in the 12-Feb Market Message. Chart 4 shows the VIX with three broad levels. Bull market volatility is yellow, bear market volatility is orange and crisis volatility is blue. Even with a sharp decline, the VIX remains above the bear market range.

Chart 4

PUT VOLUME RELATIVELY SUBDUED ... The Put/Call Ratio shows limited expansion in put volume. The CBOE Total Put/Call Ratio ($CPC) shows put volume relative to call volume. Put volume exceeds call volume when the ratio is above 1. Call volume exceeds put volume when the ratio is below 1. This particular indicator measures volume for ALL options on the CBOE (Chicago Board of Options Exchange). As with the VIX, I was struck by the lack of put volume reflected in this indicator over the last five weeks. While the S&P 500 moved to news low in February-March, the CBOE Total Put/Call Ratio did not exceed 1.20 (Chart 5). In contrast, the indicator surged above 1.4 numerous times from September to November. There was clearly a rush into puts during this panic period. Even though the VIX only reflects certain S&P 500 options, I think the relatively restraint in the CBOE Total Put/Call Ratio confirms what we are seeing in the VIX. Fear levels are running below those seen in November. Put volume surges as demand for puts increases. Increasing demand pushes put prices higher and this in turn increases the implied volatility. This did not happen in February-March.

Chart 5

SMOOTHING THE PUT/CALL RATIO... Chart 5 shows another method of looking at the CBOE Total Put/Call Ratio ($CPC). I applied the Percentage Price Oscillator (10,200,1) to smooth the data series and identify extremes (PPO = (10-day SMA less 200-day SMA)/200-day SMA). Smoothing comes from the moving averages. The Percentage Price Oscillator shows the indicator as the percentage difference of two moving averages. The indicator is positive when the 10-day is above the 200-day and negative when the 10-day is below the 200-day. I am looking for extremes when the 10-day SMA is too far above the 200-day SMA or too far below the 200-day SMA. The yellow area highlights extremes for this indicator. A move above +15% shows excessive put buying that can foreshadow a market bottom. A move below --15% shows excessive call buying that can foreshadow a market top. The red and green arrows show the signals over the last 12 months. Like all indicators, it is not perfect, but it can help define periods of excessive bullishness (below --15%) and excessive bearishness (above +15%). There were periods of excessive bullishness in late December and early February. These coincided with the early January peak and the early February peak. With the indicator near zero, it is currently in no-man's land awaiting the next extreme. You can click this chart to see the settings and save to your favorites.

Chart 6