Wednesday, February 14, 2007

Why is the VIX so Low?

A number of theories have been kicked around recently to explain why the VIX is at historical lows.

Justin Lahart re-ignited this debate with his comments in the WSJ yesterday in which he offered the explanation that:

“The VIX and other measures of implied volatility are low, in part, because investors are selling put and call options — ’selling volatility’ in Wall Street parlance. That helps to drive option prices — and implied volatility — even lower.”

Bernie Schaeffer takes issue with Lahart’s analysis this morning in, arguing against both the low VIX theory and the likelihood that selling volatility is the cause. Schaeffer cites the recent extremely tight trading range of the OEX as proof that the VIX can go much lower. He also maintains that a large majority of the option activity in question has been initiated by buyers, not sellers.

Striking a similar note, Adam at the Daily Options Report draws comparisons between the current VIX and the range-bound VIX of the early to mid-1990, suggesting that the 10-15 range may be the natural long-term range of the VIX.

As mentioned previously in this space, Jason Goepfert of has attempted to reconstruct the VIX going back all the way to 1900 and believes that the current VIX readings are not particularly low by the historical standards of the past century.

Finally, in my first entry in this blog, I proposed that the VIX had moved in four macro cycles in the 14 years since it first appeared, with a typical length of 3-5 years per cycle. According to my analysis, the current cycle of decreasing volatility began in April 2002, so the five years will be up in another two months or so.

I have no prediction for what will happen to volatility two months from now and beyond, but I will do my best to use this blog to present the various theories of why the VIX is low and refine my own thinking as I go along. In the meantime, I will continue to fade any large spikes and continue to work the bear call spread angle.


Fontimama said...

Aren't Justin and Schaeffer both missing something? If there are VIX sellers, surely there must be VIX buyers on the other side of the trade? VIX is going down because option sellers are willing to sell at lower prices and buyers are willing to buy at lower prices. This happens IMHO because risk is diminishing with increasing equity prices and "global liquidity".

Bill Luby said...

Thanks for weighing in, Lauriston.

I had a similar thought to yours, but decided that the point was that more of the liquidity was rushing in to push down the ask than to prop up the bid. If you put too much pressure on one side of the bid and ask spread, you can always find someone to take the other side of the trade. That's why (I think) Schaeffer used the phrase "initiated by buyers, not sellers" even though, of course, there was one of each for every trade.

Excess liquidity may be part of the answer, but, if so, why would it be one-sided?

Fontimama said...

bill luby

if Schaeffer is right and this was initiated by buyers, i think that is wrong because the price would rise. Every transaction initiated by buyers should lead to higher prices (increased demand), whereas seller initiated moves lead to lower prices (higher supply).

Bill Luby said...

You're right. Somehow I misread Schaeffer's quote because I was still thinking in terms of Lahart's "excess sellers" proposition that Schaeffer was looking to refute.

FWIW, I certainly agree with the conclusion that more buyers would raise prices, not lower them. It would be hard to argue the other side of that one. I guess I'll have to disagree with Schaeffer for now, but I'd love to see some hard data to support either his or Lahart's thinking.

FWIW, the WSJ has a follow-up of sorts in their MarketBeat blog today:

nodoodahs said...

VIX seems to be mostly actual price volatility of the index with a small portion contributed by sentiment of options traders ("implied" volatility). VIX is low because the actual volatility of price is low when measured as a proportion of average trading price. This low volatility is normal for where the index is today in terms of long-term momentum, as discussed on my blog and on others.

I think VIX is a trailing indicator, at best, and that one needs to pull out the information contributed by the actual volatility and look only at "implied" in relation to actual to get any information that would be useful. VIX in and of itself just doesn't have any meaning to me.

Even for an options trade, the meaningful information contributed by VIX is not its absolute level, but the mispricing exposed by comparing "implied" to historic volatility.

Bill Luby said...

I'll buy most of what you're selling, Bill, and appreciate your perspective. Where I get stuck is that looking at a graph of historic and implied volatility for VIX options does not yield the results you might expect:

What I think you are implying is that you would expect divergences between IV and historical volatility to point the way for way for subsequent VIX values. Instead, over the past 9 months or so I see almost the exact opposite happening: IV has been much higher than historical volatility while the VIX has been declining over the past 6-7 months; and when historical volatility jumped above the IV during last summer's sell-off, the VIX was mostly sideways during that period.

nodoodahs said...

My point on divergences between actual and implied volatility is that one could theoretically use them on options the way an investor might use a Price/Book or Price/Earnings ratio on stocks, i.e. sell high implied divergence and buy low implied divergence, all other things assumed equal. Say you had competing options strategies, one involving selling and one involving buying, that both captured gains from the market move you anticipate: then if implied is much higher than actual, chose the selling option, and vice versa.

I wasn't really thinking of using the divergence to predict VIX itself. In conversations with Adam, I don't think there really are suitable trading vehicles to profit directly and substantially from a predictive edge in "what will the VIX be?"

IV is the emotional component of VIX, and any recent divergence should probably be captured in terms of a longer-term relationship and not an absolute. Something like an MACD or PPO indicator with a very short (10-20 day) and very long (100-200 day) moving average to measure it. I imagine that IV could be very low or very high for extended periods, what would be useful in pricing options might be how mispriced the implied is today compared to this quarter or year, and not how mispriced today is compared to the entire history of VIX.

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