Is the VIX Staring at a Turkey Coma?

Index volatility has two distinct drivers. One is the volatility of the component stock. The other is the degree to which those component stocks correlate to one another. If correlation is strong, volatility rises -- it essentially compounds moves in individual names. Conversely, if correlation drops, index volatility drops as the moves in individual names offset each other.

Well, it looks like we're seeing a bit of the latter lately, as per this from Bloomberg:

The Chicago Board Options Exchange's S&P 500 Implied Correlation Index has dropped a record 30 percent in November. The gauge, which uses options to measure expectations about whether Standard & Poor's 500 Index stocks will move in unison, touched the lowest level since the index was created in January 2012.

… Implied correlation in S&P 500 Index stocks has plunged 48 percent since reaching a 22-month high Oct. 15, the last day of a 9.8 percent drop in the benchmark equity index spurred by concerns of slowing growth overseas.

One quick note about the CBOE correlation indices: They don't maintain constant durations, so sometimes comparing a reading from one moment in time to another can produce an apples-to-oranges sort of comparison. But having said that, the conclusion of the piece is absolutely correct.

As the author notes, that's all good news for fund managers. If everything moves in lockstep, who needs anything other than an index? But if names are moving to their own drummer, it gives the opportunity at least to find winners (and losers). It's a stock picker's market, baby!

Of course, the flip side is that it's a terrible setup for volatility and, ergo, options traders. Think of volatility as essentially the pool of available profits in the options world.

Ten-day realized volatility (RV) in S&P 500 Index (SPX) sits at 3.1 now. CBOE Volatility Index (VIX) is still near 14, so the well hasn't completely gone dry -- but that's an unsustainable relationship over time. Either RV has to lift or VIX has to drift. Or, most likely, they trend toward each other. Thus, correlation likely increases and implied volatility decreases.

Don't look for much in the way of reversion next week though. It's basically a 2.5-day trading week with a 4.5-day weekend. Throw in the "regular" weekend and you have a few slow trading days amid 10 calendar days coming up, all within a 3.1 RV backdrop. No one is paying up for time heading into that. So, we very likely see a holiday-induced VIX drop -- the question is whether it stays in its turkey coma after the break.

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