With the S&P 500 down 25 points and threatening a major moving average yesterday (the 50 day SMA), the VIX was amazingly quiet. VXX holders were left baffled, and VIX futures and option traders were probably scratching their heads in disbelief. Bonds were screaming higher as yields hit lows not seen in months, leading many of the media punditry to pontificate on a worsening economy. Yet the VIX just didn't care.
A new media theme these days is that the VIX is broken, or that it no longer measures the real fear in the market. It is said that there are other places to hedge equity market risk, or that no one uses SPX puts going out more than a week or so, thus the 30-day rolling volatility measure is an inaccurate representation of the real fear. These claims are for the most part not true.
Here is an analogy of the current situation as it relates to the volatility premium. Think of an SPX option as an insurance contract on a market disaster. There are two sides to a disaster insurance contract, and both sides have risk. The seller has to cover the principal amount in the case of a claim. When insurance prices become too competitive, and risk is not properly priced before a major event related to that sold contract occurs (an overly active hurricane season for example), insurance companies go out of business and insurance gets repriced higher by the remaining firms. This is called a soft market, when premiums are too low to reflect the true risk inherent in the contract. Warren Buffett frequently backs away from selling insurance in this scenario, preferring to sell in a hard market when there is less competition and premiums are higher, justifying the risk he is taking.
This is not unlike volatility in the options market. The VIX is a reflection of how much the SPX options cost to the equity market insurance buyer. While volatility traders and option sellers are miserable these days, those that need the insurance must be happy to be buying it at these prices. But, a wily trader understands the current condition in the marketplace and flips his volatility exposure to being a long gamma trader. More on that later.
So is the VIX "broken"? Absolutely not. It is reflecting much higher than average complacency in the SPX options market. What traders are doing, seemly reflexively at this point since they've been trained over and over again, is selling any volatility that comes along. 2013 up to the present has been a volatility sellers' paradise, where these short volatility positions rarely come back to bite them. Let's look at yesterday's SPY put behavior to see exactly how it's being pushed lower:
On a day where a major trendline is being tested, and the movement of the SPX is significantly greater than what the VIX would imply on a daily basis, the SPX put sellers and call buyers came out in force. Puts sold at the bid (right circle) outweighed put buyers and calls buyers outweighed call sellers. This is a recipe for a VIX that isn't going to rise, because put sellers are handing out contracts with the expectation that falling stocks will find buyers in the short-term. Why else would they be rushing to sell without worrying about further downside? And yesterday, they were correct yet again. You see real fear when few folks want to step up and sell those puts, raising the implied volatility, the volatility premium and thus the VIX.
But here is what can happen if you are a buyer of volatility, by purchasing SPX puts when the volatility is so low. This is the SPY option chain today:
As you can see here, there were enormous gains going out weeks in the SPY options. When volatility on at-the-money options is 10, then a 1.5% move in the index is going to send these options skyrocketing higher on pure gamma. This is how you own volatility in this environment, and I frequently break down these trades at volatilityanalytics.com. Leave the VIX and VXX alone and go out and buy the cheap option volatility. Realistically, these gains understate what really happened, as this daily chart of a SPY $187 weekly put option demonstrates:
A gain of 500% in one day could have been had if you bought the option at the open. Not a bad way to capture the volatility that the VIX products do not. The VIX is not broken; the volatility selling machine is just running hot at the moment in a nearly fearless environment. At some point in the future, a few of these insurance salesmen will be going out of business.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long volatility using calendar option spreads on various volatility products and index ETFs.