Schaeffer's Trading Floor Blog

3 Reasons Behind the Falling VIX

Why all recent VIX gains have quickly unraveled

by 6/27/2013 7:28 AM
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The taper is gone or at least forgotten for the moment.

The CBOE Volatility Index (VIX) uptrend had ended or at least stalled in a big way. It's only up about half a point from the close of June 18, the day before Big Ben's "We Might Taper Soon" remarks heard 'round the financial world.

Despite the rally over the last two sessions, the SPDR S&P 500 ETF Trust (NYSEARC:SPY) still sits about 2.5% lower than it was on June 18, so the VIX has diverged a bit in a negative way. By negative, I mean it's underperformed. What's more, 10-day realized volatility (RV) continues to nudge higher, and is now over 20, meaning VIX is at a somewhat unusual three-point discount to 10-day RV.

Now there's some reasonable explanations for all this underperformance. One is that realized volatility lags, because by definition it has already happened. There's no arbitrage potential. You can buy options at a lower volatility than what just happened, but you likely only make money if you bought volatility that's lower than future RV.

Another explanation is that the VIX ahead of the Fed reflected a small Big Ben bid-up. I joked about how this was The Biggest Fed Announcement Ever, Until the Next One, but I stand somewhat corrected. It actually did turn into a big announcement, or at least a very big reaction. So the pre-Ben bid-up made some sense in hindsight.

And finally, it is still the beginning of summer, and we still do have a very slow and abbreviated week on tap. The VIX is somewhat reflecting the fact that traders don't like to pay time decay on slow weeks, and thus lower their options bids.

The action in iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) and VIX futures supports the last explanation. The VXX is up 8% since the June 18 close, which is pretty astronomical, relative to the lift in the VIX. Normally it moves about half of VIX, so a 1-2% remaining overall pop would be in line. The calendar doesn't really affect VXX and VIX futures, so there are times when they provide a better tell into real volatility sentiment. Now is clearly one of those times.

Here's the VIX futures term structure compared to how it looked on May 1 (about when the market hit new highs). (Click the chart to enlarge.)

VIX Term Structure, Now Versus May 1
Chart courtesy of VIX Central

Pretty interestingly, the graph looks almost exactly as it did about two months ago. The slope is almost identical -- there's just a higher baseline, mostly because the VIX itself is four points higher. But the song remains the same there's a permanent assumption that the VIX will trend higher over time. That assumption sometimes pans out, as it did over the past two months. But generally speaking, it's a poor bet. Bidding up for future volatility feels like a good idea right now -- given the action we've seen in the past week -- but in a month, that bet might not look so brilliant.

Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.

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