TheMarketTone.com

In a perfect world the value of standardized futures on deliverable assets is determined via arbitrage argument, or FP = SP*(1+RF)^t.

But a unique opportunity arises in the pricing of futures that can not be arbitraged. In this scenario there is only one force setting the price: unbiased expectation of the future price of the asset. This is the case in VIX futures (CBOE Volatility Index Futures).

Looking at the VIX Futures, it is clear that market participants are anticipating a VIX rally starting in the next few weeks and continuing through 2008.

Source: CBOE

It is important to note, the VIX moves inversely to the S&P 500 and even more so when the S&P 500 declines. According to the CBOE:

“From 1990 to 2004, daily returns of VIX and the S&P 500 had a correlation of .56 for down S&P 500 moves and .40 for up moves. Over the same period, a 1% decrease of the S&P 500 was accompanied by a 4.26% average increase in VIX while a 1% increase of the S&P 500 was accompanied by a 2.30% decrease in VIX. “

So clearly VIX Futures traders are anticipating a sharp rally in the VIX, which would likely be correlated with a 5%+ decline in the S&P. Add this to why I am not buying the market’s recent rally.