The VIX closed at 16.95 today with a 30-day forward looking implied volatility of 97.30. A far move from earlier this month where the VIX threatened to go single digit.
Take a look at the IV vs HV chart below.
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| Red: IV; Blue: HV |
In a future post, I'll try to convince you why looking at the implied volatility of the VIX proves to be more useful than the actual VIX itself. But for now, see that the last time the markets were this fearful was earlier this year in January where we hit a pretty severe dip in the indexes. The S&P500 went from 1750 to 1640 in approximately eight trading days. Three days ago, the S&P hit an ATH of 1985 and closed today at 1930 in a day of heavy selling.
Looking at the implied volatility of the VIX is a strange concept. Fundamentally, you are looking at the volatility of volatility. The VIX itself is the value of the 30-day forward looking volatility of the S&P. A VIX value of 16.95 implies Wall Street is pricing in a 4.2% move in the index options. (The math behind that calculation)
So now, we look at the implied volatility of the VIX. This, in turn, represents the market expectations of how volatile the VIX itself will be. In other words, this metric (the volatility of volatility) represents how fearful of fear the markets are. A higher implied of the VIX indicates that market makers believe that in the next 30 days, the VIX could make a more extreme move than if the value of the implied volatility of the VIX was lower.
(An interesting side note: notice how the historical volatility (the realized volatility) is much higher than the implied. One way to interpret this is that VIX options might be "cheap" if you consider that the actual volatility is much higher than where Wall Street prices the risk of the instrument.)
How can we better interpret what the vol. of vol. represents?
The VIX is a derivative. It derives its value from the behavior of another instrument (remember, the S&P500). We have derivatives in physics. Acceleration is the value of velocity change over time (remember from diff. eq.'s those dy/dx's). Velocity is the change in position over time. So we are in essence looking at rates of change.
So think of the VIX as velocity, that is, in a relatively linear fashion, how much fear is currently present? Now, think of the implied vol. of the VIX as acceleration. How fast can Wall Street's fearfulness build up? A high implied of the VIX says not only that the markets are spooked, but that the fear could build up much higher very soon. Does a high implied volatility necessary imply that all this fear will be realized? Absolutely not, but Wall Street is pricing risk as such.
One final interesting chart I'd like to show is the sales of puts vs. calls on the VIX.
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| Green: Calls sold, Red: puts sold |
This chart spans the time period from August 2012 to today (Note: Keep in mind that this chart is on a log scale. I thought it would highlight the contrast in put vs. call sales). The difference between longs and shorts in the VIX seems to be pretty high compared to the past two years. At the end of today's trading day, July 31st, for every 10 contracts in the VIX traded, 8 were calls and 2 were puts.
I want to say one final thing, however. I'm not spouting doom and gloom about the equity markets. In fact, I might still be fundamentally bullish on the US indexes. The data as of recent though does show that the markets are anticipating some bumps in the road ahead. But as always, hedge your risk.
#vix
