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Monday, June 1, 2009

VIX below 30, is the Market Stabilizing? An Options Forecast

With the VIX closing below 30 (historically high level) as of Friday, could this mean the market is actually stabilizing? The VIX shot above 30 on September 15, 2008 and has stayed above it (closing value) ever since. The VIX has closed below 30 three times in May; on the 19th, 20th, and last trading day the 29th. However after closing at 29.03 on May 20th it quickly got back above 30 and closed above 30 until the 29th, where it closed at 28.92. If we can stay below 30 and eventually move lower, I believe it will attribute to the overall confidence in the market, and push the market higher. Looking at the chart below, we can see that the last time the VIX closed below 30 was on September 12, where it closed at 25.66, this correlates to the S&P 500 at 1251.70.



I am not saying that because the VIX closed at 25.66, the next time we hit that level the S&P will magically be at 1270. However I am stating that it should attribute to a market rally. The chart above shows the VIX (red and white) and the S&P index (green), and as you can see is almost perfectly negatively correlated. As the VIX gets higher the market sells off, and as the VIX drops the market rallies (this should make sense).

Historically entering the summer months the market does not perform as well as the other months, however if the VIX could stay below 30 and get lower, it may help to keep the rally going into fall.

Using Options to predict the probability the VIX is below 30:


As posted on my blog about VIX options, we can see that the options market is factoring in a 49% chance (risk neutral probability) the VIX closes at or below 30 by June expiration (all data as of market close Friday May 29). If we go out to July the options market is factoring in a 56.6% chance (risk neutral probability) the VIX will be at or below 30 at July expiration.

Hedging against volatility:

One way I hedge against volatility is to purchase call contracts on the VIX. I am currently in a 35/37.50 option spread (learn more about options here) for the July expiration. My cost was $60 per contract with a 32.9% chance (risk neutral probability) it'll return over 300%.

In conclusion I strongly believe that the market is starting to show signs of stabilization, and could continue this rally into the summer if the VIX continues to fall.

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