As Market Hits New Highs, VIX Takes a Tumble

Early last week, I saw an article on CNBC that talked about investors moving back into equity funds for the first time in six months.  This development was followed by the election, the Fed announcement on the latest round of quantitative easing (QE2), and the subsequent strong rally in the equities market.

Finally, when option volume was announced for last Thursday at 25 million contracts it was one of the biggest trading days we have seen during a non-expiration week all year.  Put these together with the fact that the market is at its two-year highs, and what do you think it does to volatility?

If you guessed that implied volatility comes in considerably, you would be right.  The CBOE Market Volatility Index (VIX) has dropped below 20 and closed at 18.26% as I wrote this piece.  While it is not at all-time lows, you are seeing it near the bottom of the last two years.  This past April, the VIX dipped below 16 momentarily, right before we had the Greece sovereign default scare and the May 6 flash crash.  Implied volatility quickly went up and then exploded in May.

Does it make sense that Vol has come in so much with all that is going on?  I think there are two camps on this:  one says that with the holidays coming, the elections giving gridlock a mandate, and the government supporting asset prices with its easy monetary policy, volatility should be considerably lower than it has in the recent past.

The other camp notes that with the market breaking out of its range, investor interest coming back into the equity market, and massive easing of monetary policy, we could see some large moves going forward.   Volatility will be more normal, not less.

One thing I would say is that even if there is a big move to the upside from here, the VIX will most likely not go back up to 40, but that does not mean there will not be volatility in the market.  Volatility is market movement, both to the upside as well as the downside.

Should there be a scenario where the economy starts to pick up and investors turn away from bonds and jump back into equities in a large scale asset re-allocation,the market averages could really move hard to the upside.  The big “if” is whether or not the economy can get moving.  If it does, watch out above!

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