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Wednesday, June 13, 2012
What Happens To VIX After Greek Vote?
- Last week, VIX declined from extremely overvalued state as measured by my FVE Indicator back down to fair value. With the rise in VIX this week, VIX is once again moving into overvalued territory.
- If we look at history, VIX rarely stays above the 30 level, even during market corrections. In fact, right before Lehman was allowed to fail, VIX was at 20 level despite a market correction that had been ongoing for 10 months--granted VIX was highly undervalued at that moment in time in August 2008. The second chart shows that FVE was indicating "fair value" of VIX to be 25 level in August 2008.
- What is interesting about the situation now is that FVE is indicating VIX to be overvalued as seen in the graphs above. In each of the three instances of extreme VIX spikes, FVE was indicating that VIX was undervalued or at least properly valued prior to VIX soaring past the 30 level. Each of these instances were also accompanied by a market shock--events that the market was not expecting. Lehman failure in 2008, Flash Crash in May 2010, and the second bailout of Greece in August 2011 and its implications for effects of contagion to larger European economies.
- So the answer to the question "What happens to VIX after Greek Vote?" really depends not so much on the outcome, but what is already being discounted in the equity market. Would Greece voting to leave the Eurozone really be a negative for the markets? Were not the markets really concerned about contagion to Spain and Italy? Has not Spain already succumbed to brutal market pressure and raised an unofficial white flag? Are not forces already in the midst of trying to attack Italy?
- The first condition that puzzles me is why the S&P500 Index remains above its 200-day moving average despite all the negative developments ongoing in global markets and the global economy. The second puzzling condition is why my FVE indicator has been consistently below VIX for the past month indicating that VIX is overvalued (after it had been above VIX the prior two months indicating that VIX was undervalued). The logical conclusion to this is that (barring any unexpected shocks like any other Euro members choosing to leave besides Greece) even if the US market correction continues, sudden plunges in the S&P500 Index is not likely and thus sudden spikes in VIX is also not likely.
- Perhaps a good trading strategy would be to buy put spreads or sell call spreads on VXX or July VIX options (since July VIX futures are trading at a premium to the VIX) ahead of the weekend. Always control your risks.