VXN:QID Ratio Reflects Unusual Complacency

With the Fannie/Freddie bailout getting no better than mixed reviews, the U.K., Germany, and Spain apparently headed for a recession, and continuing turmoil in emerging markets, sometimes I am surprised to see any green at all on my screen.

On the other hand, I’m sure some are wondering how close we can be to a collapse in the world’s financial system if the VIX is trading in the 24s.

It’s a valid question – and one I have addressed in the past on the blog with the benefit of several indicators which help evaluate how much complacency is in the market. One of these is a ‘fearogram,’ which measures the ratio of changes in the VIX to changes in the SPX. A similar tool is the VIX:SDS ratio, which compares the relative movements of the VIX and SDS (the double inverse ETF for the SPX) to historical patterns.

Below I have created a chart of the VXN:QID ratio, a sister to the VIX:SDS ratio. This chart compares volatility in the NASDAQ-100 index (NDX) to the double inverse ETF for the NDX. There are (at least) three ways to think about complacency in this chart:

1. the absolute level of the ratio
2. the level of the ratio relative to the 10 day simple moving average
3. the level of the ratio relative to the 100 day simple moving average

Looking at the chart, consider that lower readings generally correspond to lower levels of complacency (i.e., less volatility and fear per unit of decline). The current ratio is moderately low on an absolute scale, but is lodged neatly between the 10 and 100 day SMAs. What I find particularly interesting about the chart is that in those instances in which the VXN has experienced a sustained rise over a period of several weeks or more (see top section of graphic), the current situation is the first time the ratio has not risen on par with the VXN. This development is a divergence worth watching and one which appears to favor the bears.

[source: StockCharts, VIX and More]

Thanks to all who responded to my call for help about creating blog posts in Word and publishing them to Blogger. For the record, this is my first post using Windows Live Writer, which has been up to the task so far...

New 2008 Low in the DJIA, Yet VIX Shows Complacency

I have received a number of questions and comments in which readers have expressed surprise about the relative complacency in the VIX (currently at 23.51 as I type this) while the DJIA is in the process of making a new low for the year.

One important and often overlooked element of a VIX spike is surprise. Similar to Nassim Taleb’s idea that a black swan cannot be anticipated, if all of the Bob Janjuah’s of the world predict an impending market crash, the media runs with the story, and investors rush out to snap up portfolio protection…then it becomes much less likely that people will panic and the market will crash if stocks start to turn down. Put another way, where there is a safety net, there is a lot less fear.

Another point worth noting is that the DJIA is not representative of the broader markets, as reiterated by Adam at Daily Options Report today in Lookout Below? The Russell 2000 and NASDAQ-100 indices, for instance, are showing considerably more resiliency in the recent downtrend.

Turning to the VIX:SDS ratio, which I unveiled last August in Fear vs. Volatility (follow the links for some background and explanatory notes), I use this indicator to evaluate the amount of fear and complacency in the market relative to market movements. The size and direction of the gap between the current ratio and the 100 day SMA or the 10 day SMA and the 100 day SMA provide some useful information about the incremental sentiment involved in market moves.

At the moment, it looks as if the VIX:SDS ratio is showing a small amount of complacency, which I find a little unusual for the current market environment, but not particularly noteworthy. Of course, if investors see the monster approaching and prepare themselves accordingly, it is a good bet that the monster will never quite make it close enough to terrify the markets.

Complacency Up Pre-FOMC

For anyone who follows the VIX, the headline above should not come as a surprise, but here the indicator adds a little color to the story.

The VIX:SDS ratio is something I introduced last August. In essence, it plots the VIX against the 2x inverse ETF of the SPX to help determine to what extent the VIX is just moving in the opposite direction of the SPX and to what extent there is an emotional component – either fear or complacency – in addition to the normal negative correlation.

As seen in the chart below, the VIX:SDS ratio has been largely moving sideways since September, but has been drifting steadily lower since the markets bottomed in March. More importantly, the current VIX:SDS ratio is also approaching levels not sustained since July, when the credit crisis had not yet begun to unfold. Also of interest is the 0.05 differential between the 10 day and 100 day simple moving averages, reflecting that current levels of complacency are the highest in relative terms since the launch of the SDS ETF in July 2006.

As always, where there is excessive complacency, bulls should exercise extra caution.

No Fear?

We may be stuck in a holiday time warp, but I find the lack of fear in the VIX to be more than a little surprising, particularly given the spate of gloomy headlines. I talked about this same subject three weeks ago, but the gulf between the VIX action and the news flow has grown wider and wider ever since. Is it possible that this kid has already grown up enough to get a hedge fund job?

The ISEE (below the long-term mean for the 30th day in a row) and the CBOE equity put to call ratio (spiking once again) both indicate that call buying relative to put buying is considerably below historical norms, which makes the VIX numbers even more surprising.

In times like this I turn to the VIX:SDS ratio. As shown below, my proxy for the fear premium component of the VIX is now showing a reading that is substantially below the 10 and 100 day simple moving averages. Is this merely a case of desensitization or is something else going on?

Not a Lot of Fear or Volatility Lately

Given all the gloom and doom headlines across the mainstream media and blogging world (the lines are already blurring, it seems…) I am a bit surprised to see how little journalistic panic (embellishment?) has translated into market panic.

Starting with the graphic to the left, which depicts the frequency that the term “VIX” has appeared in blog posts with a certain minimum Technorati authority level over the past 180 days (see original tool), it almost appears as if the VIX is an idea whose time has come and gone. Lately, the talk is all about subprime, CDOs, SIVs, with interest rate spreads as the scorecard de jour. The markets may be down 10%, but with the VIX at 26 and change as I type this, the VIX is not part of the story.

In my ongoing effort to attempt to differentiate between fear and volatility, I turn to the VIX:SDS ratio at moments like these to see how fear has waxed and waned while the markets have fallen rather dramatically. The one year chart of this ratio is below. Previous incarnations of the VIX:SDS ratio chart have all been of the 6 month variety, but I think it is important to look at the current market environment and be able to compare it to the February-March and July-August VIX spikes (the SDS inverse ETF only launched on 6/13/06, so it is not possible to capture the ratio during VIX spike from 5/12/06 to 6/13/06.)

There are many ways to think about this chart (keeping in mind, of course, that it compares an oscillating number with a beta of about -4.2 to a trending number with a target beta of -2.0), but what I keep coming back to is the distance between the current reading or 10 day SMA and the longer-term 100 day SMA. In some respects, this isolates the magnitude of the fear component of the VIX and in the chart below, it underscores how little fear there has been relative to the recent drop in the SPX, especially when compared to similar values in February-March and July-August. I am not sure exactly how to interpret this, but I suspect that either the market will recover to a level that is commensurate with the fear, or perhaps we will see a significant VIX spike well into the 30s that will likely signal a near-term bottom. And despite what you read elsewhere, not all market bottoms require a high volume capitulation session, with an accompanying VIX spike.

ISEE Highlights Froth

Just in case it is not already obvious to anyone who may be an occasional reader, the VIX and the ISEE are my two favorite measures of market sentiment.

Right now the VIX is suggesting that the current market environment is overheated. This is evident in measures such as the distance the VIX is below various moving averages, the VWSI, and the VIX:SDS ratio.

Until recently, the ISEE was a little more prone to fence-sitting, but that changed with yesterday’s 187 reading, the highest single day reading since August 2006. On the heels of that large number comes a wave of call buying this morning that has the ISEE at 270 as of 11:10 EDT. Now it is not unusual to see extreme readings in the ISEE early in the day, when the denominator is low, but what is unusual is to see those extreme readings get even more extreme as the day wears on, such as the ISEE actually jumping up from 257 to 270 during the last 40 minutes. This development bears watching…

VIX:SDS Ratio a Keeper?

I’ll be the first to admit that I keep track of a boatload of silly VIX charts (hey, it’s better than a house full of cats…) that no person in their right mind should ever bother with, but every now and then one speaks to me in a convincingly enough fashion that I keep going back to it.

So here I am with the VIX:SDS ratio chart again. Alan Greenspan says that the holy grail of market forecasting is a fear vs. euphoria indicator. Frankly, this one is good enough for me – at least for the moment. Given that the SDS ETF has only been around since July 2006, there is little in the way of historical information with which to do some backtesting, but I like how the VIX:SDS ratio has been acting during the recent market action. The ratio may not be a perfect way to decompose the fear and volatility components of the VIX, but it certainly offers a fair share of clues. One way to look at the current reading, for instance, would be to interpret only a small fear premium built into the ratio vis-à-vis the more ‘normal’ sentiment expressed by the 100 day SMA.

If anyone has thoughts on this indicator – pro or con – feel free to use the comments section below to make your opinion heard.

Another Look at the VIX:SDS Ratio

Back on August 10^th, when the markets were testing the first set of lows, I toyed with several indicators that I thought might help me better separate fear from volatility. I published a 10-day chart of one of those, the VIX:SDS ratio.

I have been keeping an eye on this ratio during the past 2 ½ weeks and noticed that the extreme reading of .633 it did an excellent job of flagging the recent market bottom. I am still not sure how useful the VIX:SDS ratio may be going forward, but I thought a six month chart might be interesting analytical fodder for those who like to contemplate such matters. As always, comments are welcome.

As a quick reminder, SDS is an ETF that is intended to track at 2x the inverse of the SPX. More information is available from ProShares.

Fear vs. Volatility

Astute observers may have noticed several instances over the past few days where VIX tops and market bottoms have parted company. Part of the reason for this is that the fear component of the VIX has recently grown large enough that it has sometimes overshadowed the volatility component. We have a lot of volatility at the moment, but we have more fear than we have seen in a very long time.

It is difficult to decompose fear and volatility by looking at charts, but one worth examining is the ratio of the VIX to the SDS, which is the 2x inverse ETF of the SPX. The graphic below is a 10 day chart with 30 minute bars, with the SPX behind it in gray. It shows the type of mirror image you would expect between volatility and market movements up until the latter stages of Wednesday’s session. From that point on, the formerly predictable negative correlation becomes significantly muddier, to the point where today’s session shows the ratio way out of proportion to the market downdrafts.

Some of this decoupling is clearly traders buying puts to protect themselves against Monday’s headline risk, but I do not believe this is the entire story. As the markets have rallied during the course of the day, the VIX to SDS ratio has remained stubbornly higher, suggesting that the fear component of the VIX may now be the tail wagging the volatility dog. I will see if I can do a better job of coming up with graphical data to support my contention, but you can now see and feel the fear in the markets, even if it is not that easy to isolate it in the charts.