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Why the Big VIX Move May End Soon

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Fear is here, courtesy of North Korea.

Just a couple weeks after the VIX hit an all-time low, volatility is exploding as traders start to price in a potential conflict with North Korea.

This morning, the plot thickened after China said it won’t help North Korea if it launches missles at the US. However, it would not stand for the US attacking first.

Way back in July, I used options to make a leveraged bet on the VIX, and the huge spike in the VIX put the trade in the green.

I took off part of the position yesterday just before the equity market close, and will likely close out the rest this morning.

At the end of this piece, I’ll outline why I may soon speculate on a VIX collapse.

That makes now a great time to go through our 4 sentiment indicators to see if the crowd also sees sunshine ahead for equities.

(click here for a primer on the 4 sentiment indicators below)

1) VIX Spread – Bearish

The VIX is at 16.57, which means it’s nearly doubled the July 26 all-time low at 8.84.

The 3-month spread is at -1.05, which means the curve is inverted and short-term fear is very, very high.

(click here for a primer on the VIX spread)

2) CNN Fear & Greed Index – Bearish

The Fear & Greed Index is at 31.

The F&G Index operates on a 1-100 scale, and a reading of 31 qualifies as Fearful.

3) AAII Sentiment – Neutral

The latest AAII Sentiment Survey shows that 33.7% of individual investors are bullish.

This 33.7% reading isn’t terribly far off the 38.5% long-term average, and indicates that individual investors are basically neutral.

4) CBOE Equity Put-Call – Bearish

The CBOE Equity-Put Call ratio was at 0.88 Thursday, which is well above the long-term average of 0.66.

The 3-day moving average is 0.79, which is also well above the long-term average.

These numbers indicate that traders are very bearish.

Conclusion

But of 4 sentiment indicators, we have:

  • 0 bullish (down from 2 last week)
  • 1 neutral (flat)
  • 3 bearish (up from 1 last week

In July, the crowd was absolutely nutty.

But as we’ve seen many times this year, at the first sign of trouble, fear is getting priced in awfully quickly.

The action is quite reminiscent of the April 13 volatility spike when the US dropped a 22,000 bomb on ISIS forces in Afghanistan. North Korea and Syria were also in the news.

On that day, the CBOE equity put-call jumped to a whopping 0.96 with a 3-day moving average at 0.81.

And as of yesterday, the CBOE equity put-call jumped to 0.88 with a 3-day moving average of 0.77.That dip was very short liveed, and the SPX soon spiked 60 points.

This chart shows the SPX vs. the VIX (VIX is the purple line, with the April volatility spike highlighted:

So I’m looking to close out the rest of my VIX position, and actually speculate on a VIX decline, likely through VXX put options.

(UPDATE at 9:45 a.m. ET: I am now short VXX call spreads, and long VXX puts)

To make a very long story short, the term structure of VIX futures puts a downward force on VXX over the long run.

Shorting volatility has been the best trade of 2017.

But the recent volatility spike likely had traders being forced to do 3 things:

1) Close outright short volatility bets on VIX/VXX puts cover shorts
2) Buy SPX/SPY/QQQ puts and VIX/VXX calls to hedge their short volatility exposure

And now we’re looking at an inverted VIX curve and traders likely overpaying for VIX options.

Meanwhile, China’s posture indicates that they want no part of a North Korea offensive. Saying they won’t tolerate a US aggression allows them to save face, and seems like a happy medium.

If the fear gets ratcheted down, I suspect the VIX will be back in the 10-12 range in fairly short order.

I’ll provide an update if I actually make a trade.

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