It is disheartening to see financial pundits promoting low levels of VIX (VIX) as a sign of complacency without putting these low levels in proper context. Counting too much on mean reversion behavior, without any reference to the realized movement uncovers a logical flaw in their argument. Understanding what VIX represents and how it works can help in unfolding the fallacies promoted by financial experts on low levels of VIX.
Market participants have framed an expectation, believing a simple (linear) relationship exists between market turmoil and VIX levels, and volatility reversals coincide with market tops. Therefore, many financial experts are characterizing current market as complacent. Another important fallacy associated with VIX is it being portrayed as a fear gauge. Readers should note that VIX merely reflects the expected movement in the S&P500 (NYSEARCA:SPY) index, independent of the direction. Rather, a strong move higher in the index can substantially lead to a higher level in VIX as well.
Experts continue to present their reasoning behind the collapse in volatility in the marketplace. Simply, macroeconomic volatility translates into volatility in financial markets. Therefore, collapse in macroeconomic variable volatility over the last two years has resulted into low volatility in the financial markets globally. Historically, swing in interest rates preceded the volatility in the equity markets; any policy shift suiting to stronger economic activity will drive volatility higher. Some experts assert that dwindled demand for risk protection stimulates speculation. Low credit spreads, and a yield frenzy despite lackluster job creation point towards optimistic investor sentiment.
First and foremost, investors should understand that VIX reflects markets expectation of volatility for the next 30 calendar days. If market participants sense risk 6-month out or one year out in future, VIX index will fail to reflect it. Elevated equity risk premium demanded by investors for bearing added risk in equity market suits to that fear. In addition, slow muted movements in the market indices over the course of this year have pushed the spread between realized and expected volatility level to uncharted territory. To get a better feel of complacency, investors should review volatility of volatility, and skew levels which reflect the true demand for hedging against tail risk. Rising skew represents increased likelihood of outlier returns, corresponding to the demand for protection against tail risk. The chart below (borrowed from CBOE's website) highlights the ebbing demand for tail risk protection in late 90's amid the back drop of higher volatility. Contrary to late 90's behavior, depressed realized volatility in the index pushed VIX levels lower before 2007 but skew continued to rise, reflecting increased demand for tail risk.
(Source : CBOE Website)
Also, investors need to recognize the impact proliferation of volatility related exchange traded products and inverse ETFs had on volatility in the marketplace. Traditionally, institutional investors are long the market and buy insurance to protect against market catastrophes. Shorting volatility to produce excess returns has attracted many institutional players, curtailing the rise in volatility. Sharp reversals in VIX levels shortly after crossing 20 levels seen noted since March 2009 reinforce this assertion. Also, selling out of the money calls to buy downside protection drives VIX lower as well. This behavior sets in motion a self reinforcing feedback loop, noticeable during 2013 when participants were heavily short upside calls, and a rising S&P500 pushed them to cover their upside exposure, driving market to all time high levels.
Contrary to expert's assertions, long-term downside protection on the S&P500 is already priced at 16 percent volatility levels, reducing the leverage provided to volatility buyers. One can argue, these so called experts have underpinned their recommendations on absolute dollar amount. Low dollar amount still contains a higher carry cost part and if the market continues to stay calm, carry cost losses will outweigh the benefit of volatility protection.
Disclosure: The author is short SPY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Short via calendar spreads.