Schaeffer's Trading Floor Blog

Is the VIX 'Too Low' at 16?

Is CBOE Volatility Index (VIX) analysis overdone?

by 8/11/2014 9:18 AM
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So, on Saturdays I usually go cut and paste CBOE Volatility Index (VIX) data from Yahoo! Finance into my Grand Master Spreadsheet. Anyway, I stumbled on a CNBC video there: "Is the VIX underpricing risk?" It was some of the Options Action gang talking VIX. I'm not real sure I know their answer after watching it, but it was interesting seeing some public wisdom on the subject.

My takeaway is that the first guy agreed with Josh Brown the other day. VIX under 16 is just moving with the market and a concurrent indicator. Except when it goes below 12 then it's complacency, and a bad sign for the market. It leads to VIX pops within six months.

That's probably true, except that's not a real selling point for VIX 12 as an indicator. VIX generally pops within six months of any random date.

His other observation was that volatility in July and August is generally a bad sign -- I guess, worse than a lack of volatility in July and August?

OK, the clip gets much better with the second and third traders. They (accurately) point out that September is often one of the more volatile months of the year, and a 16 VIX suggests we'll see a range above 1% on about one-third of all trading days.

All of which leads to the original question -- is the VIX actually underpricing risk?

As I noted the other day, VIX has a negative 0.75 correlation to the SPDR S&P 500 ETF Trust (SPY). That sounds high and it is a strong relationship. But that number also means that the SPY move only "explains" 54% of the VIX move (0.75 squared). So we can more or less say that about 54% of the VIX price is simply a reaction to the immediate market, and 46% is anticipation of future volatility.

Over the course of time, VIX carries about a 4-point premium to backward-looking historical volatility (HV), which means that the default setting on VIX is to anticipate an uptick in future volatility. On Friday, VIX closed at 15.77, and 10-day historical volatility of the S&P 500 Index (SPX) closed at 13.88. So, on one hand, we can see that VIX does see a continuation of the trend up in realized volatility (remember, it was under 5 at times this spring). On the other hand, it's less "optimistic" about a continued lift in volatility at this point. And, in all fairness, 10-day HV lifted thanks to the fact that Friday was a high-vol day -- but it was high-vol on a rally, which will virtually always result in a narrowing of the implied volatility premium.

So the looking-backwards part of VIX is very normal right now. But the other way to look at it is that the 46% of VIX that glances ahead really isn't saying anything. And given the endless stream of bad headlines we see, it sure seems like VIX around 16 is too low.

I honestly don't have a strong opinion on the topic, which would, of course, make me a lousy TV panelist. My hunch is that VIX is very fair now. There's one common thread that ties Ukraine, Iraq, Gaza, Ebola, and everything else together: we actually know the stories already. That is, to the extent the market cares about them, they're discounted in prices on some level. So to me, if you think VIX is underpriced, then you almost by definition think there's a story out there that's not "in" the markets yet. Or a worsening of stories that already sounds pretty bad. It sort of reminds me of a few years back when Black Swans were all the rage. Everyone was identifying all sorts of Black Swans that were out there, but the very fact that we already knew well about them meant they weren't actually Black Swans.

So, short story long, at 12 VIX, there's just about nothing unusual priced into the market. At 16 VIX, we've factored in some bad news and uncertainty. It's not historically high at all, but it's very much in line with the current market, so I'm going to say we're pretty fairly priced here.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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