The Only Thing to Fear is Fear Itself

The VIX closed today at 16.87 with a 30-day forward looking volatility of 100.42.

The VIX has nested itself comfortably above 16, with the area between 14.5 and 15 acting as support. A few days ago, I talked about the volatility of the VIX itself (remember, the volatility of volatility). Based on the price of VIX options, one could infer that VIX contracts were trading at a premium that priced in about a 4-point move in the volatility index itself.

Put another way, sellers of options in the VIX wished to receive a premium to mitigate the risk of the VIX moving 4 points. The relative amount of risk premium that sellers wish to receive roughly translates to the implied volatility. However, as with all bidding processes, the buyer and seller must agree on a price. So not only did sellers wish to receive the 4-point move premium, buyers of VIX contracts found this to be a reasonable price.

Put even another way, if the price of the underlying instrument moves the exact amount that the implied volatility dictates (assuming all other things equal), the change in the option's volatility will offset the change in its delta and neither the buyer nor seller will have profited nor lost off the transaction.

 Below is a chart of the VIX's implied and historical volatility.

Red: IV; Blue: HV

The current implied volatility of the VIX prices in about a 4.5-point movement. As you can see the implied volatility has hit levels that are high relative to a majority of this year. Of course, this isn't really surprising considering the fact that the world is currently in a somewhat precarious environment. "Somewhat" is obviously only my opinion, but considering the following:

The last time the VIX reached these levels was earlier in January. At that point and time, there were looming concerns of our national productivity due to the harsh winter and also general uncertainty about our greater economic recovery.

Fast forward to July. The market generally agrees that the economy has recovered or is undergoing a significant recovery, better economic figures are printing, and Wall Street is buying overall positive Q2 earnings.

However, taking a look at the implied volatility of the VIX shows that fear has been building for quite some time underneath the surface. Even at the VIX lows that approached single digits earlier in July, the implied was quite elevated, indicating that markets were still concerned about some looming risk and willing to pay a premium to hedge that uncertainty.

At the end of today's trading day, Aug 5th, we have much more to worry about than we did a few months ago. Geopolitical instability has erupted at a global level. A global superpower threatens to invade Ukraine, violence erupts once again in the Middle-east, concerns of an Ebola outbreak in Africa spread to America, the western United States is experiencing the worst drought in recorded history, Argentina is on the brink of default, five years of quantitative easing are finally come to an end, and markets are bracing for an eventual increase in interest rates.

According to the current level of the VIX, these factors cause the greater markets to price in a 5% move in the S&P within 30 days (which is a decently sized move relative to how the S&P has been moving) and the VIX itself to move in the approximate range  [12, 21].

Depending on one's perspective, the VIX may be overpriced and this would present a good shorting opportunity. After all, fears of global instability have threatened humanity for thousands of years and here we still are (myself currently enjoying a nice cup of coffee inside an air conditioned coffee shop). Another perspective may be that recent global events are a bigger cause for concern than where Wall Street currently prices it and that this may be the perfect opportunity to be long on the index. And finally, one could also believe that markets are efficient and the VIX is exactly where it should be.

I'll try to provide a technical analysis in the coming days.