Now we know why the VIX dropped 9% on a quiet day.

From Cara Community

The S&P 500 is trading up an unexciting 2 points today, representing a gain of just 0.2% on a quiet Columbus Day. However, a look at the VIX (CBOE Volatility Index) shows a surprising 9% decline in market volatility on today’s essentially flat market (VIX is now -1.84 at 18.87). This can be explained by a mechanical shift in the options used to calculate the VIX, rather than a drastic change in market sentiment amid today’s action.

The VIX measures 30-day expected volatility of the S&P 500 Index, implied by near- and next-term put and call options. According to the CBOE, the near-term options must have at least one week to expiration, and when the near-term options have less than a week to expiration, VIX “rolls” to the second and third SPX contract months. This looks to be the explanation for today’s move. The VIX is rolling out of the October contracts (which exhibit elevated implied volatility to account for the first big Q3 earnings reports prior to this week’s expiration; i.e. INTC, JPM, GOOG, etc), and into the November contracts as the front month of the VIX calculation. The next-term options are now the December expiration cycle, since November is now the front month.

So, although it’s a dull day, which might normally see a slight decline in market volatility, today’s outsized move in the VIX appears to be more heavily influenced by the “roll” forward in the underlying contracts used to calculate the index, rather than any drastic change in market sentiment.”

While the VIX “appears to be more heavily influenced by the roll forward” it still means demand for downside protection is abating. No need to spend premium on insurance policies that rarely seem to be needed; QE II is on the way, idle cash pays you nothing, time to throw caution to the wind and get on board for more upside!

There very well may be more upside, but when the weekly VIX hits the lower Bollinger Band (currently 17.6 versus a close today of 18.96) the odds favor a pick-up in implied volatility and an end to gently sloped, one-way advancing markets.

The tension on the air is palpable – currency wars lead to trade wars, the end result being protectionism – never a good thing for equity markets.

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