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Yesterday afternoon a mentor who taught me a tremendous amount when I was his assistant many years ago sent me an email pointing out the following:  At less than 20.25 yesterday morning, the VIX reached a new '09 low and a new 14 month low; but the Nov futures continued to trade at 23.90 - a premium of 3.65 to cash.  Furthermore, the maturity curve for VIX futures had steepened sharply in recent weeks. All of this would suggest that futures traders are anticipating increased volatility as we head into year end.

As you can see in 2 charts below, over the longer term anticipated future equity volatility extrapolated from the options market (VIX) has typically exceeded realized volatility, while long dated futures on the VIX have typically traded inside a tight range of the underlying index. In the late spring of this year, that relationship started to resume after the extraordinary volatility of the second half of 2008 severely distorted the “normal” relationships. In recent weeks however, these relationships has begun to distort in the opposite direction, with the VIX declining less than realized volatility while the resilience of longer dated futures prices suggests that futures traders are anticipating a resumption of higher volatility in the coming months.

DIVERGING VIEWS ON VOLATILITY - a2

DIVERGING VIEWS ON VOLATILITY - a1

The VIX options market meanwhile is sending more mixed signals than the futures. November calls are trading at a pronounced premium to equivalent puts. This makes a good deal of sense as the upcoming weeks prior to expiration straddles the remaining earning cycle –with the VIX at such low levels recent historical standards, the calculated bet that earnings surprises could spark a rebound in volatility does not seem farfetched. At least one investor may be taking a contrarian   view however, even as the VIX rebounded sharply in the second half of yesterday’s session a persistent buyer appeared, gobbling November 22.5 strike puts in unusually large size (this following heavy activity in November and December puts in earlier sessions –see chart below). Whether this buying actually represents conviction that volatility will continue to decline, or if it is simply a hedge executed by a trader with heavy long exposure, is a matter of conjecture.   

DIVERGING VIEWS ON VOLATILITY - a3

From a quantitative standpoint, our model identifies 25.20 as a VIX TREND line, and we expect that volatility is more likely to rise in the near term as earnings are digested fully. On the longer term, looking into year end and beyond, there does not appear to be any obvious catalyst that would be capable of driving the VIX north of 30 for a sustained period  (despite increased M&A activity).  We watch volatility in the options markets closely for signals, and as the data changes we change. This divergence intrigues us, but we have not yet drawn conclusions that would support an investment thesis.

Andrew Barber

Director