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The SPX/VIX inverse relationship

Sunday, July 26th, 2009

I’ve commented before on the nearly perfect inverse relationship between the S&P 500 and the VIX. When the SPX goes up the VIX goes down, and vice-versa.

A few people have written to say that actually it’s not all that uncommon for both the SPX and VIX to close up for the day, or for both to close down for the day.

Well, we’re both right. It turns out a lot depends on your time frame.

Below is a chart of the SPX and VIX, with each bar representing one minute. This is how I like to look at it. The almost-perfect inverse relationship is unmistakable.

spx-vix_2

Figure 1

And yet, look closer and you’ll see that on 9-3 both the SPX and the VIX closed DOWN for the day! I could say “As always, the inverse SPX/VIX relationship held almost to perfection.” And you could say “No, they both closed down.” And we’d both be right.

Far more interesting is when once in a blue moon – actually, far more rarely – you have a day such as last Wednesday July 15 (Figure 2 below). Not only was the SPX/VIX close-to-close relationship positive (they both closed up), but much more importantly, that correlation was just plain positive the whole day:

Figure 2

Figure 2

I wasn’t the only one struck by the SPX/VIX action that day – Bill Luby of http://vixandmore.blogspot.com/ wrote:

“The intraday tick for tick positive correlation between the VIX and the SPX was as strong as I have ever seen. Most of the time the VIX and the SPX move in opposite directions. Today it was almost as if someone has inverted the gravitational forces acting upon these two indices.”

What does it mean? In response to a comment, I wrote the following on July 16:

“So my best guess is that yesterday’s VIX anomaly represents skepticism that the stock market rise is for real, which is quite bullish.”

In other words, my take on it is that that day the SPX rose steadily to close almost 27 points higher. But the more it rose, the more SPX option traders refused to believe the rise could last, so the more they bought portfolio insurance in the form of SPX options, driving the VIX higher.

Rising bearishness in the face of rising prices is of course strongly bullish. And indeed, in the 7 trading days from July 15 to July 24, the S&P 500 cash index rose from 932 to 979.

Days such as July 15 – as charted in Figure 2 – occur so rarely they’re hard to study. But when you see the normal minute-by-minute inverse SPX/VIX relationship broken for an entire day, it seems clear to me that the market doesn’t buy that day’s trend. Meaning there’s a high probability it will continue for the immediate future.

Do 90% of Options Expire Worthless?

Saturday, July 18th, 2009

Is it true that 90% of options expire worthless? If so, according to a popular argument, it proves that option sellers have the advantage over option buyers.

What a wonderful example of false logic. It leaves out the essential question, namely – how much do option sellers win on winning trades vs how much they lose on losing trades?

In other words, if you win a dollar 90% of the time – but lose $50 10% of the time, then you’re still a net loser.

The basic truth of being an option seller is well-known to every professional option trader. You will make money most of the time but get killed occasionally. And a one-time loss from a catastrophe can easily dwarf profits made over 10 years of steady markets.

I’ve seen it argued that you can make money selling options while hedging your risk. That’s like saying I can be paid for assuming risk yet actually take no risk. Doesn’t work. The myth of risk-free profits underlies such legendary blowouts as Long Term Capital, Bear Stearns, Lehman – the list goes on and on.

The truth is that no successful trader is either a 100% buyer of options or a 100% seller. The trick is to understand the market and do the right thing given current conditions. Sometimes that means being a buyer of options, sometimes a seller, sometimes a spreader. There’s no simple formula for success.