The bottom line is: Based on SPX historical volatility, the VIX has room to move lower.
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The "VIX premium" is the percentage that the VIX was above the 20-day historical volatility reading of the SPX.
Based on the current 20-day historical volatility of 19.1, a VIX reading of 27.5 or 28 could be viewed as expensive.
Note, for example, that when the VIX peaked in March, the historical volatility on the SPX was 23.1, substantially above current levels.
Let's take a look at these readings going back to August 2007 and compare the VIX close with the historical volatility of the SPX.
But the above should give one food for thought in terms of taking historical volatility into account when determining what a "high" VIX reading really is.
When the VIX reading and SPX historical volatility converge following a period of weakness, such situations usually mark bottoms and precede a period of bullish price action.
Implieds for AA options are elevated at 68%, but they are not excessively bid up compared to historical volatility, which rests at 51% for front-month options.
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Part of the reason that the VIX is "low" can be attributed to the fact that the 20-day historical volatility on the SPX is relatively low, currently at 19.1.
Right now, SPX 20-day historical volatility is just over 8.4, which would suggest the VIX is relatively high, even as it trades at chart support and may be considered relatively low by most portfolio managers.
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Until Mr Engle came along, people interested in such things financial types, mostly, but also regulators used crude measures of historical volatility, looking back over a year, say, to see what the average of the swings was.
Given the steady demand for index and ETF put options that have accompanied the rally, put premiums have risen considerably relative to call premiums, driving the VIX to a substantial premium relative to SPX historical volatility.
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The broad market is vulnerable to trading in a range during the next few weeks, so you might find index premium-selling attractive, with the CBOE Market Volatility Index near 17 and SPX 20-day historical volatility at 10.05.
As you can see on the chart below, when the VIX is at a discount or is trading at a small premium to historical volatility implying cheap portfolio insurance major short-term buying opportunities have occurred during the past several months.
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So, when observing the VIX, the "fear factor" is determined by the degree in which SPX implied volatilities, as measured by the VIX, are priced above the actual (historical) volatility of the SPX.
Traders positioned for 39% volatility on what has traditionally been a fairly static Sallie Mae share (as of Wednesday, its historical share price volatility was just 7.8).
Mark Hulbert, a columnist for MarketWatch, an online news service, points out that, if historical levels of volatility prevailed, we should expect the stockmarket to gain or lose 2% once a month or so.
This is done by extrapolating a company's earnings out five years, then weighing its expected earnings and dividend streams against its historical stock price volatility (reflecting risk) and the AAA bond yield (reflecting opportunity cost).
The reason is that such a document spells out a logical asset allocation given one's financial goals, discusses the historical levels of volatility inherent in the chosen allocation and mentally prepares the investor for the harsh reality that periods of "black swan" events do happen.
But there are historical periods, especially choppy volatility ones, when the rebalancing bonus is significant enough to bend the mix of a blended portfolio well above either component by itself.
Armed with all this historical evidence, I think investors who are able to stomach the added volatility should consider buying a basket of small, value-priced, high-dividend-paying stocks.
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While past performance cannot guarantee future results, and asset allocation cannot ensure a profit or protect against a loss, applying a historical perspective and maintaining an appropriate strategic asset allocation can help provide comfort and direction to investors during periods of great volatility.
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