Why Is The VIX Not Screaming Higher

If you thought Monday was ugly for global equities, it didn’t get any better on Tuesday. U.S. equity indexes fell sharply, again, on Tuesday with the Dow Jones Industrial Average (DJI) leading the way lower by 2.2 percent. The Dow was down more than 630 points intraday at its lows. The Nasdaq (NDX) fell 1.7% and the S&P 500 (SPX) fell back to its October lows, finishing down 1.8% on the trading day. The VIX rose roughly 12% on Tuesday followed by a much lesser move in the Volatility of Volatility Index (VVIX), which was only up by .45 percent.

As the market declines have persisted since October and after a brief relief rally, some market participants are a little confounded as to why the VIX has remained elevated, but not expressing the extremes the equity market is expressing in price level value. Let’s face it, an almost 2% move lower on the S&P 500 Tuesday and the VIX only jumped 12% on the day. Another question investors are pondering along the same lines is that the VIX has not reached the peaks it reached at the October SPX lows, even though the SPX has essentially revisited the same low levels.

On Tuesday, the SPX “double-bottomed”, at least for now. This indicates that the lows from October were hit once again and after several weeks. More often than not, during a correction period, the initial lows are retested before either the SPX moves higher or lower. The chart below depicts the SPX (blue line) with a VIX layover (purple line). What is very clearly indicated in this chart is that the VIX did not reach its peak from the SPX October lows even though the October lows have been tested here in November. Why?

Firstly, the VIX is a stochastic process, a derivate reading of S&P 500 (SPX) options. The VIX is priced from a portfolio of S&P 500 options defined by the CBOE, and the futures price from the market’s expectation (Implied Volatility) of where the VIX Index will settle at expiration. One component in the price of SPX options is an estimate of how volatile the S&P 500 will be between now and the option’s expiration date.

There is no one reason as to why the VIX has achieved the October peak level, but a confluence of reasons to consider. If anybody says the VIX is relatively lower than the October level when the SPX is at the same levels today, this would be a farce. Some of the variables we look at when drawing conclusions about the VIX are further explained.

S&P 500 Tail Risk

One of the factors we look at in deciphering VIX probabilities or levels near-midterm is the SKEW Index. What is the SKEW Index? Here is how the CBOE describes it best.

“The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500® returns. Investors now realize that S&P 500 tail risk - the risk of outlier returns two or more standard deviations below the mean - is significantly greater than under a lognormal distribution. The Cboe SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew".”

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