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3 Reasons The VIX Is Low And Why It May Stay That Way

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With the S&P 500 hitting new highs, the valuation debate is getting more intense. Some say the market is rich, pointing to lofty levels of cyclically adjusted price-earnings ratios. Others say it is fairly valued, sighting its relative cheapness to the bond market. Few will argue the equity market is complacent. Sentiment indicators, including the put/call ratio, stock price breadth, the flow of funds, and confidence surveys suggest investors are still willing to take risk at today’s price levels. The most-watched indicator of complacency, though, is the VIX Index.

The VIX measures the level of expected, or implied, 30-day option volatility of a basket of S&P 500 Index options. It is sometimes referred to as a “Fear & Greed” index because it tracks investors' appetite for risk so closely. When investors feel confident, they purchase fewer put options to protect against losses on their equity holdings. And in fact, many seek to generate returns by selling options (even at the currently historically “cheap” levels) on the assumption that future stock market moves will remain muted. At 10%, the current level of the VIX is depressed enough to make the front pages of media publications along with predictions that the lack of sufficient “fear” in the market is setting the stage for an imminent market correction.

The numbers don’t lie. The VIX is low. But a de minimis VIX, by itself, does not necessarily cause a correction. It’s important to understand why implied volatility is depressed before we can forecast a reversal. The strong bull market in global equities is the primary driver, but there are other forces at work.

1. Low realized volatility translates into low implied volatility

When you ask an options trader if volatility is rich or cheap, the first place they look for an answer is the implied/realized ratio. The ratio compares market expectations for volatility over the next 30 days to the level of historical volatility over the previous 30 days. Implied volatility is derived from current one-month option prices; realized volatility measures the “choppiness” of the stock price over the past month via a calculation of the annualized standard deviation of the stock’s daily returns over the last 20 trading days.

In most scenarios, implied volatility trades at a premium to historical volatility because option buyers are willing to “pay-up” for insurance. Non-traders may think selling short-term equity volatility at 10% is crazy, but if the market is currently generating only 7% actual volatility, traders who sold options can hedge their short position every day and still be quite profitable. Buyers are still paying a premium at 10%, and sellers are happy to sell options to them at these reduced volatility levels.

Garth Friesen

The ratio is not static, and in some cases, it can be misleading. Implied volatility is a forward-looking number and realized volatility is backward looking. Think of the price of volatility as similar to other forms of insurance. When the recent hurricanes approached Texas and Florida, people in the possible path of destruction drove up the cost of “insurance” by stocking water, fueling their cars and boarding up their houses. This happened before the storms came ashore. The impact of the storms was not felt until days later. The concept is the same in the options market: implied volatility anticipates movements; realized volatility records what actually happens. Right now, investors have little fear of the future because of a very favorable past.     

Note that the level of the VIX is always higher than the level of implied volatility. Why? The index is calculated using a combination of options with different strike prices- not just “at-the-money” strikes. Investors pay a premium (in volatility terms) for options that act like lottery tickets. The out-of-the-money low strike put options, for example, will be very cheap in terms of price, but expensive in implied volatility. The high volatility of the “lottery tickets” drives up the VIX relative to the at-the-money strikes.

Garth Friesen

2. Short volatility strategies have grown in popularity 

Option buyers are comfortable paying a premium for implied volatility over realized. As a result, option sellers, over time, make more money than option buyers. It’s the same reason insurance companies are profitable; they take in premiums with the expectation they will occasionally pay out claims. Sometimes they underprice risk and pay out more than they take in, but most of the time they just collect their premiums. The notion that there is a persistent “alternative risk premium” built into option prices has attracted investors to exploit the phenomenon. Hedge funds and other investment funds systematically engage in volatility selling across all asset classes, especially in the liquid market for short-dated equity options. Even retail investors have jumped on the bandwagon by buying ETF’s which short VIX futures. In a world of ultra-low interest rates, the “carry” associated with these strategies is attractive.

Wall Street firms end up owning most of this short-dated volatility. As a result, these dealers are very quick to capitalize on any market movements to offset the time decay in their option books. Dealers buy the dips and sell rallies. This “delta-hedging” acts as both a floor and ceiling to large intraday market movements, thereby muting stock index movements, which pushes realized volatility down, and keeps the VIX level below 10.

3. Stock correlation is low

Correlation is a measure to describe the degree to which stocks move together. On any given day, some stocks rise and other stocks fall, fluctuating on their fundamentals and technicals. In some environments, such as those categorized as “risk-on” or “risk-off, individual stocks lose their identity and tend to move in tandem. When this happens, the majority of stocks in an index will move in the same direction, either up or down. In a low correlation environment, stocks don’t move together. You could have half the stocks in the index down 10%, the other half of the index up 10%, and the index itself remains unchanged. Individual stock volatility is very high, but index volatility is not. The VIX is a measure of index volatility, not single stock volatility.

Correlation is currently low. The one-month correlation for the S&P 500 is 18%, compared to an average of 36% over the last five years. One-month realized correlation even got as low as 3% in early August. The lack of correlation translates into lower realized movements of the index. Some stocks are soaring, but others are falling. Significant changes in individual companies do not necessarily mean large changes in the index.

All of these factors add justification to the current level of the VIX. A spike in realized volatility and correlation is just one geopolitical event, or one tweet away. Recently, these spikes have not deterred the systematic program sellers of volatility. Their behavior will determine whether the spike is temporary or sustained. So what will put an end to these programs? A period of prolonged losses. Until that happens, it’s too early to call the end to the low VIX environment.

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