Messages From The VIX Curve

Much has been made of the recent decline in the CBOE Volatility Index (VIX).In just two weeks, we have seen VIX fall from around 20 to just over 17. That is a significant change in a short period of time, and many have viewed that as a sign of a more sanguine market. That perception is generally correct, but the VIX futures traders appear less convinced that volatility has been truly vanquished.

Please bear in mind my ongoing warning: VIX is not explicitly the market’s fear gauge. Yes, VIX tends to rise during market declines and ahead of major news events, but that is only a reflection of traders’ demand for hedging protection and speculation. Over the past year, speculative demand for options has played an increasing role in the pricing calculation. We need only to look at the past week for an example of this phenomenon. On Monday, VIX rose 3.35% on a day when the underlying S&P 500 Index (SPX) rose 1.44% in the aftermath of an economic release that cleared up the market’s labor market concerns.

Bearing in mind that VIX is calculated from a wide range of SPX options with an average of 1 month until expiry, we need to understand that VIX was historically boosted above at-money implied SPX volatility by out of the money puts and suppressed by out of the money calls. With the recent wave of call options speculation, those calls no longer suppress VIX to the degree they used to, and can in fact boost VIX when speculators are active. That explains the recent phenomenon, which we saw on Monday, of VIX rising on up days for SPX.

We can better understand this relationship using a graph of options skew. The graph below shows the current skew of one-month SPX options (white) versus one month ago (green). The lower portion shows the absolute changes in implied volatilities at different delta levels for the options. 

Skew of 1 Month SPX Options, Today (white) vs 1 Month Ago (green) and Differences (bottom)

(Click on image to enlarge)

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