the gap between the average implied volatility of VIX calls and

Why the VIX May Not Be Best Market Indicator Right Now
Published: Tuesday, 7 Sep 2010 | 12:00 PM ET Text Size By: ReutersDiggBuzz FacebookTwitter More Share
The CBOE Volatility Index is often used to predict where markets are headed in coming weeks, but now may not be a good time to rely on Wall Street's so-called fear gauge for direction.


AP
Two key tools on the CBOE Volatility Index are now showing opposing directions for the market.
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The open interest put-to-call ratio and average implied volatility gap between puts and calls on the VIX, two tools used to predict volatility, are showing opposing views. While the former suggests a decline in the VIX, the latter indicates a sharp spike.

The disparity in the numbers could either mean the market is due for a correction or the recent stock rally will keep going, analysts say.

"These two numbers are usually in agreement but they are completely the opposite now, which is very unusual to see," said Randy Frederick, director of trading and derivatives at the Schwab Center for Financial Research in Austin, Texas.

The VIX [VIX 23.8 2.49 (+11.68%) ] has been lower over the past four days, but was higher Monday.



Despite the recent fall in VIX itself, the open interest put-to-call ratio on the VIX has been rising. Generally, the ratio falls when the VIX declines as more call options are bought in the expectation that the VIX will rebound.

But the recent inverse move suggests investors expect the VIX to fall further, which typically means the market would move higher.

The VIX, a yardstick of investor anxiety, is a 30-day risk forecast of stock market volatility. The index typically has an inverse relationship with the S&P benchmark as it tracks option prices that investors are willing to pay as a protection on the underlying stocks.

Mind the Gap

However, the gap between the average implied volatility of VIX calls and puts has been widening, with the call average soaring in the past couple of days.

The average is calculated based on looking at different call and put options of varying strike prices, half of which are in the money and half out of the money.

"The gap between the calls and the puts is currently near 180 (percent). When the gap hits above 150, it's time to be very cautious about a spike in the VIX. When the gap hits 200, which it has done a couple of times, that's when the market saw a correction," Frederick said.

Fred Ruffy, options strategist at WhatsTrading.com, said the largest position on the VIX was the Sept $25 puts, with open interest of 289,000 contracts. That was followed by Oct $25 puts, which rose to open interest of 187,000 contracts after a large Sept-Oct $25 put spread trades earlier in the day.

"The large blocks of puts on the VIX might be hedges of VIX futures," he said.

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