real volatility of the S&P 500

real, volatility of the S&P 500

http://www.minyanville.com/articles/VIX-SP500-vxn-options-predictive-statistic/index/a/23246

Yesterday’s steep sell-off was accompanied by a pop in implied-volatility readings. Gauges such as the VIX and VXN rose about 11% on the day. This breaks what had been a pretty steady trend lower over the past 4 months in which those measured have declined some 40% since the market made a low on March 9.

But even as the market continued to rise in late May and early June, the VIX became sticky, remaining near 30 even as the 20-day historical, or real, volatility of the S&P 500 declined from 28 to 24 during the past month. This has led some to the conclusion that 30 was an important level that indicated the market was poised for a pullback. Yesterday’s sell-off -- and the accompanying jump of the VIX back above that round number of 30 -- seems to confirm this theory.

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One problem with this thinking is that the VIX is a statistical measure, and it's the result, not the cause, of any market move. Additionally, because it's a statistic, applying technical or charting analysis typically used on stock, isn't very effective.

But this isn't to say the VIX can’t be used as a predictive tool.

Most people tend to use it as a contrary indicator. That is, like most sentiment readings, when it gets relatively high -- an indication of fear or caution -- it's taken as a bullish sign. If it's low -- which is interpreted as complacency -- it's regarded as bearish.

The problem with this approach is that the VIX not only can stay low for extended periods -- it was at decade lows for most of 2006 as the market hit all-time highs -- but it can also rise during bull markets, such as during the tech bubble.

Probably one of the best ways to use the VIX as a predictor would be to use it for short time frames, when it doesn't respond as it should to the underlying market conditions

Where to From Here?

But for option traders, the VIX has less appeal as a market predictor than a broad measure of whether options are relatively expensive or cheap, and whether it makes sense to pursue long- or short-premium strategies.

The vega of a position -- that is, the change in value of option resulting from a change in implied volatility -- can often be the difference between a profit or loss, and is sometimes more important than being right about a directional move. STOCKSRELATED ARTICLESALSO BY...

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While it's always nice to have the wind of time-decay (that comes with being short premium) at your back, yesterday’s move was a reminder of the quick pain that can be delivered.

The Healing Process

During the height of the credit crisis, many market commentators turned to medical analogies to explain what was happening. The situation was often compared to a heart attack, where blood (money) had stopped flowing. By January, it was deemed that the heart was back to pumping, but only feebly; the patient was said to remain in intensive care, still in need of frequent liquidity injections.

The metaphor continues: Even though it will take time and the patient won't be engaging in the high-stress, risky activities he once enjoyed, a full recovery is predicted.

What happened in the option market and the explosion in implied volatility was less a vascular problem than an orthopedic one. When the market suffered a bone-crushing “break," there was associated swelling.

And the broken area is still very tender. Any new bump to the injured area can cause renewed inflammation. The patient (investor) with the memory of the intense pain will flinch, and move to protect himself by purchasing options. I suspect it's this type of behavior that will keep volatility at lofty levels.

While the VIX is still at relatively high levels on a historical basis, I think it fairly reflects the volatility and risk of the current market environment. Over time, it will likely revert back to the historically normal range of the low 20s. But for the next few months, it's likely to stay at inflated levels.