Is VIX Pricing in the 'Right' Amount of Uncertainty?

Just because options volatility is set by the market doesn't mean the market always gets it right

by Adam Warner

Published on May 8, 2015 at 8:34 AM

I believe my piece from yesterday implies that options pricing is always "right" in sort of a Nixonian way. President Nixon's defense once was that if the president did X, then by definition X can't be illegal, because the president did it. Something like that -- it was a little before my time, or at least before the time I had any idea what was going on.

With the CBOE Volatility Index (VIX), I'm afraid I sounded like "volatility is right, because that's what investors are willing to pay for it." And that's not really an accurate description.

Options volatility does get priced by "the market" -- well, unless you read a very popular tin-foil-hat sort of financial site that basically implies that the Fed decides on VIX. It's ostensibly a prediction of future volatility, but in reality it better reflects the realized volatility in front of us right now than anything else.

Of course, expectations do matter. Say there's a big Fed meeting on the horizon, and the markets are a bit frozen ahead of it. We would likely see rising implied volatility in the face of declining realized volatility. That would then resolve in some fashion after the meeting.

Thus, the best way to interpret VIX is to try to divine how well implied volatility reflects the current backdrop. The pundit whom I quoted was of the opinion that options are underpriced vs. reasonable expectations for future volatility. I'm not of that opinion.

Yes, VIX looks low on an absolute basis -- or at least, it looked low a couple days ago; not so much now (more on that in a sec). But to me, VIX looks pretty fair in the context of a market that keeps struggling to move off its relatively tight 2015 range. It's very much in line with realized volatility. We tend to trade with a modest premium of implied to realized, and that makes inherent sense. When you buy an option, you only risk the premium you paid, whereas when you sell an option, you incur theoretically unlimited risk. And all these stories out there we're so "worried" about -- slowing growth, Fed hikes, Greece, et. al. -- are known.

It goes back to that whole "black swan" thing. If we can identify a black swan before it appears, then by definition it's not a black swan. There are obviously "bad" stories out there we don't know about yet, but I can literally say that at all times. And that's precisely why implied vol trades over realized vol at most times. There's uncertainty, and there's premium in options pricing in that uncertainty. And those premiums look unexceptional right now.

As for VIX -- well, I do like to look at it vs. itself, or rather, its own price action. I define overbought as 20% above its 10-day moving average (MA), on a closing basis. It's not a magical number; it's more of a continuum. And right now, we're hovering in the high teens above the 10-day MA. So it got a bit overbought, but not extremely so.

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


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