Strengthening Correlation Between Equities and Volatility

Everyone today will likely be talking about the flash crash in the e-minis and what transpired last night in D.C. I won’t spend much time on that as there are plenty of other bloggers covering it, Josh Brown threw up a great piece last night on the topic.

What I’d like to take a look at is the interesting setup taking place between the front month and 3-month volatility contracts. Right now it seems that traders care more about volatility in the next few weeks than they do a few months down the road. This isn’t likely to shock anyone, with the fiscal cliff looming it makes sense that traders and portfolio managers are buying protection via the front-month $VIX.

I’ll often look at this ratio at market turning points as it can give an idea of how complacent or nervous traders are at market tops and bottoms. However, we aren’t at an extreme reading in the relationship at this point. But what currently makes this setup interesting is the increase in 45-day correlation between the ratio  of the $VIX and $VXV to the S&P 500.

VIX VXVThe chart above shows the ratio between the front-month ($VIX) and the 3-month ($VXV) volatility, as you can see, it’s been rising since late-November. In the top panel I’ve put the 45-day correlation with the S&P 500. Since 2010 there have only been six other occurrence of the $VIX:$VXV ratio having a positive correlation to equities. So although equities have been enjoying a nice uptrend (until recently), traders have been buying large amounts of front-month volatility contracts in relation to the 3-month volatility.

One last comment on the fiscal cliff. Price action in equities has been revolving around the whispers and press conferences in Washington for the last few months. Congress now goes on vacation (unless President Obama calls them back) until next year. What’s important going forward is what will traders focus on next. Will we get the normal end of the year window dressing or will continued speculation of the cliff still plague the markets?

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+.

About Andrew Thrasher, CMT

Andrew Thrasher, CMT is a Portfolio Manager for an asset management firm in Central Indiana. He specializes and writes about technical analysis as well as macro economic developments.

  • Awesome stuff, Andrew. Keep up the great work.

    • Andrew Thrasher

      Thanks Ryan, means a lot coming from you.