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Tales of a Technician: Implications of a Submerged VIX

May 16, 2017

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The recent rendezvous of the CBOE Volatility Index (VIX) with the single digits has the punditry class all aflutter. And with good reason. It’s a rare occurrence seen only a few times over the past 27 years. A sub-10 print on the Street’s favorite fear gauge only strikes in the sleepiest of sleepy markets. It’s indicative of widespread complacency where everything flips to slow motion mode. During such times the sun shines brightly on the Street, and dollar bills are doled out like lollipops. All-time highs are commonplace, and uptrends multiply like rabbits.

Last Tuesday the almighty VIX fell to 9.56. Here are a few implications worth pondering.

First, if you’re using the VIX as a sentiment indicator, then these signals of mass complacency could be viewed as bearish for stock prices. As the old saw goes, “when the VIX is high it’s time to buy, when the VIX is low it’s time to go.” Unfortunately, this is a monster oversimplification. The problem with trying to time the market with low VIX readings is the vast number of false signals. Unlike fear, complacency seeps into the market and lingers. Low VIX levels can persist for months on end until stock prices finally peak. If you’re intent on using the Volatility Index for market timing signals, I suggest focusing on using high VIX readings as a time to buy versus low VIX readings as a time to sell.

Second, some cite the multi-year lows in the Volatility Index as evidence that option premiums are cheap. This is undoubtedly true. After all, readings of implied volatility (of which the VIX is one) are derived from option premiums. The extremely depressed VIX reading is a direct reflection of the fact that S&P 500 options have shrunk so much. But, and this is a BIG but, just because options may be cheap doesn’t mean they are underpriced.

In theory, a perfectly priced option is one where the implied volatility you pay for at trade entry equals the realized volatility the stock experiences over the duration of the trade. So, if I buy (or sell) a one-month option on the S&P 500 with an implied volatility of 10% and the S&P 500 does, in fact, realize 10% volatility over the next month, then the option was fairly priced.

Whether or not a VIX of 10 is fair depends on how much Mr. Market moves over the coming month. But as of recent history, a VIX of 10 actually isn’t even low enough! Check out the following chart of the S&P 500 ETF with a 20-day historical volatility (HV) reading in the bottom panel. Lest you were unaware, historical volatility is the indicator we use to measure how much the market is actually moving – its realized volatility, in other words.

Notice how the HV has been submerged beneath 10 for the entire year? That’s dead, folks. Deader than dead. And it means that even though the VIX has been languishing around 10 or 11 most of the year, it’s entirely justified.

Yes, indeedy, option sellers have still been banking coin shorting premium with a bottom-of-the-barrel-scraping VIX.

Until we see actual market volatility pick-up, don’t bet on a rising VIX anytime soon.

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5 Replies to “Tales of a Technician: Implications of a Submerged VIX”

  1. barrykroschel barrykroschel says:

    thanks very interesting article

  2. Avatar JINGLI says:

    Good article, thank you Tyler

  3. FrancesK FrancesK says:

    Thanks Tyler! I thought the VIX was being manipulated, not because HV was really that low. It’s good to know.

  4. ScottMills ScottMills says:

    That helped to put things in perspective. Thanks Tyler

  5. Avatar CHARLESZELEWSKI says:

    Thanks Tyler, good perspective. I always appreciate the way you dissect complicated subjects.

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