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Tuesday, June 19, 2012

VIX Is Now Undervalued

According to my FVE model, VIX is now undervalued.  As of 9:20am CST, June 19, 2012, FVE's value is 19.5 while VIX is 17.7.  Granted tomorrow morning is VIX expiration--VIX tends to be very volatile and less reliable closer to expiration because small changes in bid/ask spread of out-of-the-money S&P500 Index options can change the value of VIX significantly.  So VIX could easily rise to 19 on purely technical reasons without much implication to the markets.  Having explained that, VIX is still undervalued.

Because VIX is not a tradeable instrument, we need to analyze VIX futures related instruments.  VIX July futures is at 21.6. Given that VIX futures usually trades at a premium over VIX, it seems now fairly valued to slightly "undervalued with one month to go before its expiration.  Furthermore, VIX August futures is at  23.6, which means that VIX futures contango is steep.  This steep contango, were it to persist, would continue to put considerable pressure on price of VIX futures related instruments such as VXX.  The reason is that VXX carries daily rolling positions of first two front month VIX futures.  VXX would be selling some of cheaper VIX July futures to buy more expensive VIX August futures causing it to lose some of its value each and every day as long as contango persists.  Because of this, VXX may not rise even if VIX does.

Some form of action by central banks to support the financial markets seems to be fully reflected in the markets now, and if the US equity market remains stable than prices of VIX futures related instruments like VXX could continue to fall.  Last week, my FVE model indicated that VIX was considerably overvalued and VIX futures even more so ahead of the Greek elections. I suggested shorting volatility in my post "What Happens To VIX After Greek Vote?". Now, with VIX and VIX futures related instruments having plunged, the risk/reward profile appears no longer to be in favor of staying short VIX futures related instruments.

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