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VIX Is Not Too High, Part Whatever


Chief Strategist at Interactive Brokers

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.

Over the past few months, we have seen speculative call prices creeping above at money options as well.  Had you ever heard the term “gamma squeeze” before the past few months?  As speculators gravitated to using call options to supercharge their trading strategies, options sellers have been forced to adapt.  The problem is that most sellers failed to fully anticipate the enormous wave of demand for out of the money calls that arose in this current bull market.  Much of the recent focus has been upon waves of buying in highly speculative individual shares, but SoftBank’s massive call buying in NASDAQ megacaps last summer was perhaps the more meaningful effect.  Even though their buying was concentrated in individual shares, the sizes of both their trades and the market capitalization of affected stocks were enough to influence pricing across major indices.  Just as the Crash of ’87 was sufficient to permanently affect options skew to the downside, the Gamma Squeeze of 2020-21 is likely enough to boost upside options for the foreseeable future.  In other words, skew has become more symmetrical, and that is boosting VIX.

Let’s consider SPX implied and historical volatilities, displayed in the graph below:

SPX implied and historical volatilities

Source: Bloomberg

SPX shows an implied volatility of about 17.  That is in line with its 20 day historical volatility. Remember that 20 business days is about 30 calendar days – the target range of VIX.  

Now let’s consider the effects of out of the money options, displayed in the graph below:

Source: Bloomberg

We see that both “wings” – 20% up and down from at money options (blue and green), have implied volatilities above those of their at money counterparts (white) for nearly the next two months.  When we account for boosts to VIX from both types of out of the money options, a 21.5 reading is not unreasonable.

Of course anyone is free to decide whether VIX is likely to increase or decrease from here – that’s trading.  But starting an assumption that VIX is simply “too high” is not borne out by the evidence.

Links reference in the article:

Clearing Up Some Common Volatility Misunderstandings

Disclosure: Interactive Brokers

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