Why VIX Is So Low, And What Comes Next?

Tyler Durden's picture

VIX is nothing more than the market's implied 'factor' that makes the supply-demand of options prices fit with model-based parameters. In simple terms it measures the market's expectations for volatility (up or down moves - not just down) going forward. Empirically it has a relationship with realized volatility - how much the market actually moved up or down relative to what VIX expected - and professionals will use various 'scalping' techniques to lock in day-to-day gains from the difference between the market's actual movement and what options prices expected. To wit: the current expectations of central bank action, just as it did in 11/2011 (global CB action) and 1/2012 (LTRO1), has caused a slow steady leak higher in stocks which crushes realized volatility - currently at record lows. This in turn drags implied vol lower as the 'scalpers' sell vol to capture the difference. With September 'events' around the corner, we suspect there are only a few more days before realized vol picks up and implicitly implied vol momentum scalpers are squeezed out again.

SPY (the S&P 500 ETF) Realized vol (orange) is following the same collapse path (red ovals) as it did in LTRO1 lead-up and the global CB action in November. Clearly the market is not willing to chase realized vol all the way down and maintains a premium (lower pane) which it appears to be up against here...

The lower pane above is the critical part to understanding market expectations for a risk pick up.

 

Clarifying: VIX 'expects' a certain move per day and as long as the move is smaller than 'expected' then a daily profit can be garnered... of course this works every day day in and day out until it doesn't and the market (and realized vol) rips your arms and legs off (as we show with read arrows below)...

 

The bottom-line is that a low VIX must be compared to its realized vol to judge real exuberance/complacency... but we note that there is a floor to the premium vol sellers are willing to accept to take on the rip-your-arms-and-legs-off probability. While implied vol provides insight into expectations of risk ahead, it is the premium to realized vol that tells you the real story and currently that premium remains very high - in other words, the market IS expecting considerably more volatility ahead (lower pane of first chart above).

Charts: Bloomberg