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Sunday, September 30, 2012

Differences in Perception & Reality: Time to Go Long Volatility

Back in late August and early September, and ahead of ECB announcement, S&P500 Index experienced a period consolidation.  As you can see in the first blue oval, the market went sideways, then took off after  Draghi's announcement of Outright Monetary Transactions (OTM) policy.  Over the past two weeks, the market has also undergone a consolidation of sort.

The interesting difference between these two periods of consolidation is VIX (shown in plum) movements and my Fair Volatility Estimate or FVE Indicator (shown in blue).  As you can see indicated by the red arrow, VIX steadily rose ahead of the ECB announcement to 18 level, while FVE remained low and in a declining trend.  After the ECB announcement, VIX plunged.

Recently, however, FVE has been steadily rising, yet VIX has remained mostly below FVE Indicator's values during this consolidation and also below its values during the previous consolidation.

The reality is that the current ongoing consolidation of the S&P500 Index is showing greater volatility, yet market volatility perception as measured by VIX is not quite reflecting this.  I believe presents a good expected payoff scenario in favor of going long volatility.

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