The VIX is Too Low…Here’s Why and Why You Should Care

Contemplating Agents of Spill-Over and the Impact on Vol

Is 30 VIX the Right Level?

Amidst the punishing sell-off in markets, there is active discussion about the VIX and whether it is high enough. We argue that the index is too low and in doing so, we assert that the price of insurance does not adequately reflect the combination of how options are carrying in real time and in the set of financial tail risks that may emerge from the Fed’s inflation fight.

What Drives Index Volatility?  Revisiting the “5 C’s”

There are a myriad of factors that impart upward or downward pressure on implied volatility. A short-hand for these factors is the “5 C’s” framework – carry, credit, calendar, concern and capital. Among these, the most prominent influence on the level of implied vol is how options carry. And on this measure, a metric often cited is the premium of the VIX to realized.  With the VIX at 29 and 1m realized volatility at 29.6, the spread sits in the 12th percentile over the last decade. Using the last 2 years, when options have carried particularly poorly, the spread is in the 9th percentile.

Looking Beyond Carry…Have VIX Hedges Worked?

If owning options on implied vol is a logical hedge against a market drawdown north of 20%, logic has not prevailed recently. A simple strategy of buying and holding 20 delta calls on the VIX in 2022 is down 7.5% and has lost money every month but for January. Favorable comparisons of implied to realized volatility notwithstanding, the ineffectiveness of using VIX calls to play defense argues against the notion that the index is too low. Trades that work – both on the short and long vol front - invite sponsorship. Levels of both VIX call option volume (3m average is in the 24th percentile over the past decade) and open interest suggest a lack of interest. Vol of vol books do not appear to be especially large.

Carry Matters, But So Too Does Capital

There were long stretches in the post-Pandemic period when equity index option carry was awful. Sharpe ratios on vol selling strategies were excellent in 2021, by some measures approaching 3. The height of the implied to realized premium was on GME day - 1/27/21.  Then, the VIX was 23 points above concurrent 1m realized. Why? The explanation here provides some clues on what may be under appreciated in the current environment. The VIX reached 37 when the “GME VIX” exceeded 500 because option demand greatly outstripped supply.  This is the 5th pillar of our “5 C’s” – “capital”.

But SPX 1m realized vol was only 14!

Why were investors willing to pay so much for an option on 1/27/21 amidst so little index movement? The answer lies in the massive widening of the distribution of lower left outcomes that the GME price spiral imparted on markets. This was insurance pricing similar to that associated with the precursor of a contagion event.  Recall that the VIX spent a bunch of days in the 30’s in immediate aftermath of the Lehman bankruptcy. Sometimes, the risk measure needs time to catch-up. In 2008, as more evidence emerged on the severity of the issue, the VIX got into the 40’s and 50’s.

Drawdowns, Realized Vol and the VIX…Some Historical Perspective

How does the current SPX drawdown compare to prior periods of weakness in the context of realized and implied volatility. The table below looks at DD incidences of 15% or greater over the past 2 decades. While the GFC and Pandemic are uniquely severe risk episodes, it becomes clear that the VIX is currently low when set against its level at the bottom of other meaningful sell-offs (far right column).

40+ VIX, Three Episodes to Consider

In 3 prior tail events when the VIX got to the low 40’s, LTCM in 1998, the telco bust in 2002 and the Eurozone sovereign crisis in 2011, 1m realized volatility also surpassed 40. Those periods saw not just several 4% one-day moves in the SPX, but 5 and 6% moves. These contribute a tremendous amount to a realized vol series. In 2022, we’ve seen some very large daily swings, but nothing more than 4% so far.

Modern Markets Are Vulnerable to Toppling Over

Have the tracks already been laid for a 40 VIX? There’s an argument to be made and a risk to be considered. That risk results from the reality that modern markets are not built to self-correct, especially from price shocks of this magnitude. In assessing what is coming next for the economy, the impact of the wealth destruction that has already materialized may be important. This same wealth destruction matters in a financial sense as well.

What we observe is the tendency for spill-over events to occur when asset price damage gets significant enough. Markets become more illiquid, collateral requirements are tightened and there is stress on basis relationships. To wit, the BoJ’s “cornering” of the CTD contract in the JGB market and the resulting impact on the cash/futures basis. Risk taking is compromised when market prices deteriorate and liquidity strains emerge.

Sources of Spill-Over

De-risking in one area of the market may have knock-on impact. There are several places to look: crypto, USDJPY, JGBs, Italian sovereigns, energy and the back-end of the US yield curve. These are among the fragile assets that could become a more central part of today’s dynamic, effectively widening the distribution of potential outcomes for equity investors. Underpinning each of these factors is the Fed’s inflation fight and a dual mandate that is conflicting for the first time decades. Risk managing inflation from above, the Fed has been forced to turn vol buyer. The result: excluding the GFC and Pandemic, the highest rate vol in 2 decades.

Reflexivity Redux

George Soros once said, “price is the only fundamental.” This is especially applicable today. In this rendering, price is a proximate cause, sometimes a positive agent that enables growth of the system. The risk now is the reverse of this.

The VIX Is Too Low

The previous discussion is meant to highlight 3 overlapping factors that play a role in setting the VIX. Carry, Concern and Capital. On the isolated merits of carry, the VIX screens favorably. Beyond the comparison of realized to implied, there is currently insufficient pricing in the vol surface of deep left tail outcomes. This pricing was prominent in 1998, 2002, 2011 and during the GME episode of 2021. Today’s ratio of the VIX to 1m ATM implied vol on the SPX sits in the 2nd percentile over the last 10 years. Such a low reading illustrates the “disrespect” being shown the deep OTM puts that play an important role in the VIX calculation. Simply put, there is not enough concern reflected in the market price of convexity relative to the set of risks that may already be in motion. If market participants are forced to more fully contemplate these sources of spill-over, demand for tail protection will rise and the forces of supply and demand (capital) will push the VIX higher.