VIX Analysis By Schaeffer's Research

What the Trader is Expecting in the Coming Week: Call Trading Builds on CBOE Market Volatility Index
By Todd Salamone, Senior Vice President of Research

At risk of sounding like a broken record, we continue to monitor the option activity on the CBOE Market Volatility Index (VIX). Unfortunately for the bulls, what we are seeing is not pretty, as the heavy call activity on the VIX that we have alluded to during the past couple of weeks continues. This call activity indicates that speculators are expecting the VIX to rally, which typically coincides with broad-market weakness.

Going into Friday's trading, another 63,000 VIX calls were added during the week, versus only 8,000 puts. In fact, for options expiring in the next 3 months, there is now more than 700,000 VIX calls, the highest since November 2007.

The VIX call activity is very reminiscent to the May and June 2007 period, which preceded a rough patch for the market into late July. A marked slowdown in this VIX call accumulation would be a signal that a short-term bottom is in place, as such call accumulation has proven to be smart. As the VIX inches up toward the 30 area, site of the November peak and the strike with the heaviest call open interest in the March series, it will be interesting to see if the call accumulation finally begins to subside.

One potential short-term bright spot for the bulls is the data coming from the International Securities Exchange. The 10-day moving average of the ISEE call/put ratio is currently at 117, which means that roughly 1.17 calls have been purchased (to open) for every put purchased (to open). In August, this ratio hit 117, preceding a 10% rally in the S&P 500 Index (SPX) during the following 2 months. On January 18th, this reading registered 118 and preceded a 5% rally in the SPX into the first day of February.

So while pessimism among retail option players is hitting a potential short-term extreme, one caveat to keep in mind is that this ratio has reached much lower levels. For example, in March 2007, the ratio fell to 102. Given the fact that the broader market is in a much weaker technical condition as compared to the March 2007 period, this ratio may have to hit even lower levels, which would probably coincide with further market weakness. We will closely watch this ratio in the upcoming week, as an advance in this ratio combined with signs of market strength would be bullish for the short term. However, a continued downtrend in this ratio would be a negative for the market....

.....Thus, despite the market being near its lowest levels, the VIX has much more upside before fear levels are identical to those in late January. It may be necessary to see a VIX spike to the mid-40s (or higher) to put in a solid market bottom. Unfortunately, this will mean that another sharp market drop would be the culprit to induce such VIX levels.

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