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Volatility Traders Suddenly Scared Of (Stock) Heights?

Via Dana Lyons’ Tumblr,

Despite the S&P 500’s jump to new all-time highs, trading in the short-term volatility market is signaling elevated levels of fear.

We mentioned yesterday that some strange developments were afoot in the stock market lately. Well, the strangeness continued through yesterday’s market action. Today we look at unusual activity in the volatility market – specifically, in the S&P 500 Short-Term Volatility Index, a.k.a., the VXST. Similar to the VIX, the VXST measures volatility expectations over the next 9 days, versus the VIX’s duration of 1 month. And like the VIX, the VXST typically moves counter to the movement of the S&P 500 (SPX). That hasn’t been the case this week.

Already up some 30% on the week, despite the S&P 500′s solid gain through Wednesday, the VXST hit another gear yesterday. While the SPX followed through to the upside on Thursday, gaining more than 0.8%, the VXST did not back off. In fact, it was up over 12%, despite the gain in the SPX.

How unusual is that, you ask? Since the inception of the VXST in 2011, it is just the 21st gain on any day the SPX rose by at least 0.8% – and easily the largest of those gains.

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Not only has the 9-Day VXST been on the rise on an absolute basis, it has also been moving higher relative to the 1-Month VIX. When we see near-term volatility indices rising faster than the further out indices, it is typically a manifestation of heightened fear. Again, this is fairly unusual given the fact that the SPX closed at an all-time high yesterday.

In fact, since 2011, yesterday was just the 18th time the VXST closed higher than the VIX (i.e., the VXST:VIX ratio closed > 1.0) on a day that the SPX closed at a 52-week high.

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So we see unusually fearful behavior in the volatility market given the S&P 500′s firm action of late. But what does it mean? Is it signaling something in particular going forward in the stock market?

Typically, we like to fade extreme moves in the markets, especially when they do not conform to normal patterns. So that would suggest bullish overtones for stocks. That said, if there is one market that we have observed as having a better track record than others of actually being “smart money” on a temporary basis, it would be the volatility market.

We are not saying that extreme or consensus moves in the volatility market are normally correct – it is the same as any other market. However, at times we have seen unusual action in the volatility market, in particular in the VXST, that has turned out to be well timed on a limited-term basis. Perhaps we are seeing the payoff of this recent VXST strength here today with the stock market experiencing a rare bout of weakness.

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