Here Is What The Real Fear Index Is Saying

Tyler Durden's picture

With so many talking heads claiming the 8% drop in stocks and VIX's jump back above 20% as a sure-fire indication that the market is in chaos and needs Fed help stat, we remind readers that VIX reflects a contemporaneous premium for up/down movements in the future offering little insight into downside risk per se and more reflective of a regime shift in market volatility - i.e. a rising VIX means market participants expect the markets to move around more (up and/or down).

 

While looking at the difference between VIX (forward volatility) and current realized volatility can offer insight into participant's concerns (or the difference between out-of-the-money volatility vs at-the-money volatility - or skew), there is a cleaner (and smoother - less spike and decay-like) way of judging the level of concern in trader's heads.

 

The implied correlation, a topic we have discussed in the past at length, quantifies the difference between the index's volatility and the summation of the underlying volatility of the names in an index. In a nutshell, the implied correlation measures the relative demand for instant liquid index macro protection relative to its underlying names (a slower less liquid way to protect yourself). The higher the correlation, the greater the risk of a very significant downside move (since correlations tend to approach 1 when systemically bad events occur).

 

 

By implicitly measuring the market's demand for this relative protection - and its implicit downside risk sentiment - implied correlation is much more applicable as a measure of investor sentiment.

Currently, implied correlation is rising rapidly - a worrying trend - and has broken back above 70% (a critical threshold from last September when capital market risk became epic). We will be watching implied correlation closely - especially relative to VIX - to get a handle on the market's relative demand for downside protection and thus a real 'fear' index (as opposed to a 'movement' index).

 

VIX remains useful in a self-fulfilling way since so many market participants watch it but with ETFs impacting the short-dated vol markets more and more, we suspect implied correlation (with its 'relative' measure of risk) may well become more focused upon.