If the Market Is Panicking, Why Isn't the VIX Higher?

07/06/2010 10:31 am EST


Adam Warner

Author, Options Volatility Trading

The holiday-shortened week and the fact that it's summer do temper it a little, but a VIX of 30? That's higher than average, but hardly at panic levels. The VIX is, of course, the Chicago Board Options Exchange Volatility Index.

With the market declining every day, where's the fear?

Well, perhaps it's because we have declined in a fairly orderly fashion the past few weeks. Check out the chart below. It shows ten-day realized volatility over the past six months.

Click to Enlarge

On average, the VIX carries about a four-point premium to realized volatility. It's a very inconsistent relationship, as the VIX quantifies implied volatility (expectations for the futures) whereas realized volatility, by definition, looks backwards. But all things being equal, VIX will average about four points above it.

But now, well, not so much. Even with Friday's drop, the VIX sits a good 12 points above realized volatility.

It may surprise you to see realized volatility so low. It sure surprised me. But this often happens with one-directional moves. We miss a bit of the forest through the trees. The daily ranges and moves are not that extraordinary. So what does it all mean?

Well, this sort of action makes both net long and net short gamma strategies quite challenging. The net long strategies may not work because the daily moves do not provide enough opportunity to flip stocks so as to offset daily decay. The net short strategies may not work because most people don't hedge them aggressively in slow markets and then get caught by the price drift in the underlying.

If memory serves me correctly, we saw similar behavior at times in 2008—ugly markets—indifferent options and much questioning as to the perceived lack of fear. That, of course, did not end well, but I would not go calling for a rerun so fast.

The iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and VIX futures do expect at least this VIX level to persist. They pretty much price in mid-30s VIX forever, or at least into December, which is as far as they list.

By Adam Warner of DailyOptionsReport.com

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