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How VIX traders are timing cliff jump

Chris McKhann (chris.mckhann@optionmonster.com)

Volatility data can be useful in many ways, and one of them is assessing the timing of events. Right now the VIX and its related contracts give us a sense of what people are thinking about the so-called fiscal cliff.

As of this writing, he S&P 500 is about 1410, having rebounded from 1350 in the last couple of weeks. The VIX is at 16.39 after climbing from 15 in the last three weeks, a level that held for the previous two weeks. The volatility index last closed below it on Oct. 4.

When the SPX was holding these levels going into the election, the VIX was above 18. The 30-day historical volatility at that time was 10 percent, but now it is 15 percent. Given those data points and the fact that we are fast approaching that dreaded cliff, the VIX seems quite low and very well may be underpricing risk. But the spot VIX is above the levels of the December futures, which expire in two weeks.

For a number of reasons it is normal for the futures to carry a premium to the spot VIX, especially in bullish equity markets. When the VIX is above the futures, it means that the expectation is for very short-term volatility. Traders are pricing in volatility for the next two weeks, but not so much into January as one might expect.

This can also be seen in the implied volatility of the SPX options as well, though a bit less clearly than a few days ago. Until this week, the January SPX puts had lower implied volatility than the December options. Right now we can see it in the SPX 1390 puts. The highest implied volatility for those puts is in the weekly puts that expire on Friday.

The December and the January 1390 puts have the same implied volatility, just above 16 percent. The "normal" relationship can be seen after that, as February puts are at 17 percent, March at 18, and June above 19.

What does all this mean? To me, it means first that volatility, in the form of near-term SPX puts, is relatively cheap. It also means that any fiscal-cliff factors are priced into the immediate future, not into January.

Increasingly, it seems as if people are expecting the budget issues will be resolved, but only after we go over the cliff. I tend to agree with that assessment.

I think our government will figure things out, or at least patch something together, but I'm not willing to make huge bets that they will do so in the next couple of weeks. And if you are unhedged into January, that is exactly what you are doing.

So I think that buying January puts--or even going out to February--makes very good sense right now. The daily talk will surely cause some volatility, but the market will make its really big moves when and if we know for sure that we are going off the cliff on Jan. 1.

If we do make that jump, the first weeks of the New Year will be a wild ride. But most people expect a resolution by the end of January, with a market plunge likely pushing the issue.

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Dec. 5.)

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