Why the Latest VIX Pop Is Abnormal

Now that we're in official panic mode as we wait for the Fed, I wanted to put this volatility pop in greater context. Implied volatility (IV) has lifted in line with realized volatility (RV) almost perfectly. Ten-day RV in the S&P 500 Index (SPX) is up to the mid-18s, meaning that CBOE Volatility Index (VIX) in the low-to-mid-20s vol maintains that typical IV-HV premium near 4.

Here's the deal, though -- that's not terribly normal. Usually when RV lifts, IV is relatively slow to follow. That's because options markets tend to assume mean reversion. Most of the time, that manifests in the aforementioned IV-HV premium at periods of low volatility. That's really a common state of the volatility market ... RV around 10-12, IV around 14-16.

And then volatility pops, and VIX goes up. But RV usually lifts faster, as now the mean reversion assumptions hangs the other way.

If you told me 10-day RV would pop from 10 to 18 over the course of a couple weeks, as we've seen, and then asked me to guess VIX, I'd have said "high teens." Clearly, I would have guessed wrong, as VIX has broken above 25.

This time is "different," though. (Isn't this time always different?)

Now we have the Fed about to come down off Mt. Sinai with their Rate Commandments. Even though there's the tiniest bit of uncertainty that they raise, there's some uncertainty as to whether they give hints regarding how far the hikes will go, how frequently they'll hike, who they like in the college football championship, and how they plan to get out of their longstanding New Year's Eve plans so they can watch.

So, yes -- it makes some sense that there's a bit of vol premium in the here and now. Throw in the high-yield bond crisis that seems to have suddenly obsessed the financial news networks, and we have a recipe for some nervousness.

But to that I counter, there's always something worrisome out there. Remember Greece, anyone? China? And hey, there's good news on the way. If the Fed hikes and the credit crisis persists, the Fed can now cut rates! I'm pretty sure someone, somewhere is making that argument.

Fed worries explain some VIX popping, but then why the VIX futures popping? That's a second derivative of overreaction, as we noted the other day. They wouldn't lift much at all if we were worried about a bad Fed reaction. Maybe some bond jitters?

It's certainly possible that VIX was just too cheap, and now it's "right". Of course, many have made that argument every time VIX has spiked in the last five years. One of these days, the pop will persist. I don't know why this is THE time, as opposed to the myriad others. I suspect the "real" one will sneak up on us over time, as opposed to starting with a blast, and it will not be accompanied by an outsized reaction in the VIX futures.

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