VIX Is Not Too High, Part Whatever

There is a financial anchor whom I respect immensely, yet echoes a theme on a basis that I do not agree with – that the CBOE Volatility Index (VIX) is too high. I had hoped to explain my rationale to him and his audience, but until I get an invitation to his show I can at least explain it to you here.

Some of you may have read a piece that I recently wrote about common misconceptions about volatility. The 2nd and 3rd items in this piece are particularly relevant here. Those refer to my opinion that the statements “Implied Volatilities are Too High” and “VIX is Too High Relative to Implied Volatility” are both incorrect in the current market environment. Further, it is my assertion that options market structure has changed in ways that could affect the relationship between VIX and at-money options on the S&P 500 Index (SPX).

VIX has systematically traded with a level above the at-money implied volatility of underlying SPX index for quite some time. This is because VIX includes out of the money options. All options with non-zero bids are generally incorporated into the calculations. That means that although the number of options can vary, there are a wide range of options strikes and deltas that enter the equation.  (See here for more details.)  This is where options skew enters the mix.

The implied volatilities for protective puts are typically above those of at money options. This has been the case for decades. The lessons of the 1987 crash became permanently imprinted upon the options market in its aftermath. Since then, we have seen continual demand for puts that can provide some insurance to a fully invested portfolio. There are not many natural sellers of out of the money puts, so the market demands and expects something extra (in implied volatility terms) for offering those options. When incorporated into the VIX calculation, those below-market puts have provided a lift to the index.

To some extent, the higher implied volatilities of below-market options have been somewhat offset by relatively lower volatilities of out of the money calls. There have historically been natural sellers of those options, either by retail and institutional investors who seek income via covered call writing or by put purchasers who attempt to defray some of the cost of their insurance by selling calls. This activity has a depressing effect on the implied volatilities of above-market options, which is then incorporated into the VIX calculation as well. The depressing effect of lower volatilities in above market options is usually not enough to fully offset the boosting effect of higher volatilities in below market options, and that effect appears to be shrinking. That shrinkage is indeed a feature of the current market environment.

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The author does not hold any positions in the financial instruments referenced in the materials provided.


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