*Update Aug. 16th: FTAlphaville takes my thinking a bit further. (here)
Sometimes I can’t help but wonder.
Watching an obviously weak S&P, I was expecting the VIX to be climbing, but to understand why the VIX is falling it’s worth a refresher on how the VIX functions and wikipedia does a decent job (here).
The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period. That is, index options are priced with the assumption of a 68% likelihood (one standard deviation) that the magnitude of the change in the S&P 500 in 30-days will be less than 4.33% (up or down).
The short answer to this curiosity is: option traders are NOT expecting higher volatility over the next 30 days even with the downturn in the S&P, which often (but not always) signals higher volatility and hence a rising VIX. In other words, option traders are not expecting the S&P to deviate up or down greater than 4.12% over the next 30 days (based on the VIX at 14.23) and that translates to 5.77 points on the S&P and 57 points on the ES.
The VIX and option traders are saying today that the S&P should be bound by 134 and 146 over the next 30 days.
This 6 month chart of the VIX is interesting because at the moment the VIX is low and options are relatively cheap.
I’m often bearish during periods that feel complacent, though traders have a real dilemma with the VIX at 5 year lows and the S&P at 6 month highs. For me the obvious response is reversion to the mean, only time will tell.