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ETF Specialist

Is Volatility Cheap Yet?

The VIX has fallen, but waiting for the next spike could be painful.

The positive surprises of second-quarter corporate earnings seem to have taken the edge off the stock market that persisted even through the rally of March through June. Even as the S&P 500 soared from 667 to 950 in the second quarter, no one quite seemed to believe it could stay so high, and widespread nervousness showed up in the daily articles predicting a double-dip recession.

That nervousness also expressed itself in options prices, which serve as a barometer of investor sentiment due to their ability to serve as portfolio insurance. Since put options guarantee a minimum price for their purchaser on a given stock or index, put option prices rise significantly when investors fear that prices could fall. Higher options prices thus predict that their underlying index will be more volatile, or more liable to large jumps in the future. Using some rather abstruse mathematics, it is possible to back the implied volatility out of a series of options prices to figure out how much market movement investors currently fear. This is precisely how the widely known VIX index (or "fear index") is calculated, using prices for the frequently-traded 1-month options on the S&P 500 Index.

The past few weeks have seen the VIX fall from near 30 in mid-June to about 25 today. Both values appear incredibly cheap compared to the peak over 89 recorded by the VIX in October 2008. This has investors scrambling for portfolio insurance. The closest retail investment to the VIX is the  iPath S&P 500 VIX Short-Term Futures ETN , which we have seen rising from $40 million in assets at the end of April 2009 to $160 million at the end of June and $365 million today. However, good as the VIX looks today relative to the past several months, we urge caution in buying insurance at today's prices. The VIX might have a ways to fall yet, and differences between the VIX and VXX would make it expensive for investors to wait out a potential benign market.

Before buying insurance, it always helps to look at historical prices. The Chicago Board Options Exchange has calculated values for the VIX going back to 1990 using the current methodology, giving us a healthy data set for comparing with today's values. The most striking initial discovery is just how high a VIX of 25 is relative to the typical range. The VIX index closed below 25 on 80% of the trading days since the beginning of 1990, and its median close lies at 18.5. Typical quiet periods in the market have seen the VIX fall below 14 on over a quarter of the trading days since 1990. Even assuming that we remain at fairly elevated volatilities relative to history, the VIX index could fall 20% or more from this point.

The risk of falling prices alone would not matter if we could invest directly in the VIX. After all, we would not sell until another crisis hits the market and the index shoots above 35 or 40 as it has reliably done in the past. However, we cannot invest directly in the VIX. Instead, the iPath S&P 500 VIX Short-Term Futures ETN mimics an investment in the near-month contracts of VIX futures traded on the Chicago Board Options Exchange. Like commodity futures, these near-month contracts converge to the spot price, causing them to follow changes in the VIX fairly closely. Unfortunately, these futures are also subject to the same dangers of contango that hurt similar rolling near-month futures investments in  United States Oil (USO) and  United States Natural Gas (UNG) earlier this year.

Investors and institutions have piled into the VIX futures in search of insurance against another dip, pushing prices into steep contango. The August contract for the VIX trades at 27, and the September contract trades over 29. If the VIX remains constant and the contango does not become any steeper, short-term futures investors rolling from the front month into the second month will lose 7% of their insurance investment over the coming month as the futures prices converge to the lower spot. It does not take too many months of such steep losses to reduce an insurance stake in VIX futures to a negligible nub. Investors who buy into this steep contango should know the price of the futures they are buying, and that the insurance they are buying will fall in value each month as they wait for the next crash.

The fairly new volatility ETNs have great potential as a hedge against unforeseen tumult. But they are not the VIX index itself, and confusing the two could result in buying insurance at the wrong time and the wrong price. For now, options prices may suggest that investor fear has quelled, but a look at the futures market that many institutions use for the portfolio insurance tells us otherwise. Until this contango starts to flatten and the spot VIX falls to levels more in line with historical norms, we do not think these ETNs provide an attractive long-term risk-reward trade-off.

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