One of the catalysts cited for the recent breakout in the S&P was the corresponding breakdown in the VIX, which as we noted on Wednesday breached the triangle formation in which it had been trapped since February, sliding to the downside and erasing the elevated levels seen in the post Feb 5 panic.
However, while the VIX has tumbled, the realized vol in the market continues to be surprisingly high. That's the take of Goldman's derivatives strategist Rocky Fishman, who writes today that "the VIX closed yesterday at its lowest level since January", a level which as he shows in the chart below, is "too low given how much the SPX is moving."
Of course, since a lower VIX means lower S&P option prices, as Fishman further clarifies, a mismatch has emerged "between how little SPX options cost (June straddle with over five weeks to maturity costs 3%) and how much the SPX has been moving (3.5% rally over the past five trading days)." This relationship is shown by the highlighted dot in the chart below, which also shows that the price of the 1M S&P straddle is now at a record low compared to where it should be based on historical trading patterns.
Or, said in simple English, the VIX has tumbled in the 13s, economic data are consistent with a VIX over 15, and its normal relationship with realized volatility would put it above 18.
This also means that the infamous vol sellers - the same ones who got destroyed on Feb 5 when the XIV imploded - are baaaaack. And, with the VIX again plunging - undeservedly so according to Goldman - the unpleasant outcome for the vol sellers is just a matter of time.
So, to underscore just how "highly unusual" the present level of the VIX is, especially in connection with realized vol, Goldman makes the following point:
Implied/realized vol risk premium is stretched to historical lows. Two metrics we monitor to assess the level of implied volatility are pointing toward a VIX that is far too low: its level relative to SPX realized volatility and its relationship with economic indicators. A regression between the VIX and its best-fitting exponentially-weighted SPX realized volatility (we see a 13-day half-life as the best match for the VIX) indicates that the VIX should be around 18.7, and that we have had one of the most persistently low implied/realized ratios on record.
As Fishman puts it visually, "2018’s median negative implied-realized ratio is historically highly unusual"
Some other reasons why Goldman is urging its clients to buy vol:
- Economic data are consistent with higher implied vol than we saw in 2017: weakening economic data are consistent with a baseline VIX level around 15.
- Implied/realized volatility ratios are low globally, but the US is the most stretched. Most major global equity indices have implied volatility below exponentially-weighted realized volatility.
So for those who agree with Goldman and believe that the vol-sellers who have fone full tilt, are in for a surprise and the VIX is set to spike, here is how to trade it and make a 6-12x return on your investment:
June VIX call spreads can provide 6-12x multiples should the VIX return to the 20’s. Given conditions supportive of higher implied vol, another SPX selloff could bring the VIX back into the 20’s. VIX call spreads provide more reasonably-priced protection against a further pickup in vol than they did in the immediate aftermath of February’s VIX spike. With risk from the VIX ETP complex much-diminished, positioning for unlimited VIX upside is less relevant.
The flipside to all of the above, of course, is that if Goldman is pitching buying Vol, then its prop traders are selling it, which all else equal, would suggest further downside, unless of course all the good Goldman traders have quit in disgust now that the once proud Goldman is actually selling subprime loans as it struggles to push up revenues and keep up with its peers. Our suggestion: wait until Gartman goes short the VIX before going all in.