When VIX 'Disconnects' from Futures: Tin Foil Hat Edition

VIX futures may not track sudden VIX spikes, but that doesn't mean a conspiracy's afoot

by Adam Warner

Published on Oct 19, 2015 at 9:43 AM
Updated on Jun 24, 2020 at 10:16 AM

Is it time to flash the "all-clear" in volatility world? Things have calmed a bit lately. The CBOE Volatility Index (VIX) is back near 15, a level it has not seen since all the way back on Aug. 19 -- ok, it wasn't all that long ago.

But at least we're calm now, right? Well, maybe not, according to the always-understated folks at ZeroHedge, which just published a piece entitled "Moral Hazard, 'Supernormal' VIX Swings, And Why August 2015 Was Just An Appetizer."

Uh oh. And that's just the headline:

"Moral hazard has contributed to a significant build up in short and leveraged volatility creating a shadow 'volatility gamma' that reinforces the current trend in volatility direction. Rising volatility is followed by more rising volatility and vice versa. Volatility is crushed whenever a central bank responds to crisis and thereafter leverage is re-applied in even greater amounts in a cycle of moral hazard. The pattern is creating a pro-cyclical monster of short volatility that, if left unchecked will contribute to a repeat of the May 2010 Flash Crash or 1987 Black Monday Crash. August 2015 was just an appetizer."

Ok, it's a bit overstated -- go figure -- but there's a kernel of truth to this thesis. Shorting vol has apparently gotten more popular. And that does pose a potential problem in that shorts have open-ended risk in an "asset" that's not really an asset. It's a math calculation, and that calculation can go anywhere. A short vol squeeze can feed upon itself. And, yes, the speed of the vol move in late August was somewhat unprecedented.  

But this excerpt and the whole (really long) piece wildly overstate both the net risk involved here and the likelihood that central banks around the world rushed in to protect some massive block of short VIX players. They exist, but they're just not so large that we're talking any sort of structural risk here. And the move itself was nowhere close to large enough to pose such an enormous threat. In fact, he notes that:

"This is a new era of hyper-moral hazard whereby a central bank reaction function is fully priced into option markets. Volatility markets do not believe central banks will let us fail.

"For evidence, consider that the VIX futures markets faded the August VIX spike by the greatest margin in history."

Ok, now I get it. The vol move was so large and scary that vol didn't really move. In other words, the VIX moved a lot, but futures didn't track it as much as normal.

There's very good reason for that, and it's not nefarious. The futures didn't move as much as "normal" precisely because the actual VIX move was so fast. VIX futures anticipate mean reversion. We see that -- always. The "mean" assumption isn't always correct. In fact, contra conspiracy theories, the mean reversion assumption almost always involves futures pricing at a premium to "cash" VIX, and in contango. And that assumption is almost always wrong, as VIX itself tends to underperform over time.

In August, we briefly had a period where the reverse was true. "Cash" VIX shot up and futures were slow to follow. That's normal, and in this case, perfectly correct. Futures quite simply don't assume that a VIX-plosion is permanent, nor should they. It's not always 2008 or 2002. In fact, it's very rarely 2008 or 2002. It's much more likely to be one of the countless other VIX blips that came and went, and futures treat them as such. The longer the VIX blip lingers, the more likely VIX futures will believe it's not actually a "blip," but a more lasting VIX rise. Always remember that a VIX future prices in a snapshot of VIX at the day the future expires.

I can't prove that central banks don't throw money at everything to prevent asset sell-offs, or that prices now are all wrong because nothing is real. I also can't disprove that "The Matrix" is a documentary. I would suggest, though, that we're on the tail end of a low-volatility regime, and we're just going to naturally and gradually move to longer-term high-volatility regime. And I'd suggest also that longer-term volatility assumptions don't move all that fast, whereas shorter-term ones do -- and there's nothing particularly noteworthy when there's a disconnect between the two.  

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

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