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Dropping VIX for Year-End Window Dressing?

Most of the time I consider myself a pretty optimistic guy, but sometimes you cannot put on the rose colored glasses because it just does not feel right.  I made a comment about the dropping correlation between the VIX and the returns on the S&P 500, but now it just seems ridiculous.  How much was the VIX down today?  Over 7.7%.  How much was the S&P 500 up?  A measly .19%. Just take a look at January VIX futures versus the S&P 500:

Does the VIX trade under its own power now?

I am always hesitant about things looking too good to be true.  The backdrop is that nothing has changed in Europe, the equity market has not made any significant break out rally, and treasury yields are still bordering on levels of absurdity…despite that, the VIX and other short term measures of equity implied volatility have dropped substantially in the last few weeks…to a point where they are the VIX is braking down to July levels, and significantly below where the S&P 20 day historical vol:

First let me state my position: I am short implied volatility.  This move is a big positive for me, but I still have to ask questions regarding its staying power.

The first question you have to ask is whether it is real.  I have a hard time believing it is real considering the lack of European resolution or substantial market rallies.  It is possible that the VIX is leading the charge, but I find it hard to believe.  The second question is regarding the technicals – is the holiday season along with light trading driving the perception of short term trading risk.  I could believe that it will be quiet going through year-end, but I find it hard to believe that there is not a risk of renewed fear starting in January after the holiday glow wears off.

My own thought is that a bit of window dressing is going on.  Nearly all banks are short implied volatility through their over the counter trading books.  A strong decline in implied volatility is highly beneficial for all of the bank’s derivatives books.  Can they force a move in the market like this?  It is hard to prove, but I do seem to witness quite a few convenient market artifacts going into December 31.

Only January will tell the truth, but for now I am very willing to reduce my own risk.

Posted in Derivatives, Markets, Trading Ideas.

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