The Cheapest Volatility

The VIX hit its lowest levels since 1993 this week, and that captured headlines. Whats most interesting to me is the spread between realized and implied volatility. Realized shows how much the market is actually moving, whereas implied is what the market thinks volatility will be.  During sudden shocks or crisis’ (BRExit) realized volatility can trade above realized. In normal markets realized is less than implied.

The chart below shows current implied (yellow line) vs realized (blue) in the SPY.  I like to think that (during “normal” markets) when the spread (the gap between the lines) narrows that volatility is “cheap”. For instance December in the chart below. In April there was major hedging of the French elections, so the IV spiked way up. The underlying market however didn’t budge.


Whats interesting about the current market is that realized volatility is essentially at historic lows. It could drift a bit lower, but its basically on life support. Implied volatility has really dropped after the French election as well, almost to the level of realized. So the situation is that realized is about as low as possible, but implied is right there with it. If they are both literally on the floor there are only two outcomes:

  1. Volatility continues to trade sideways
  2. Volatility gets up off the floor

I am not forecasting impending doom, I am just noting that it seems to me that the risk reward of shorting volatility is not as good as it was a few months ago. So, whether you’re long XIV, short VXX or in variance swaps I’d be cautious.

Someone Says Volatility Doesn’t Measure Risk

Notes from:

Volatility: A Misleading Measure of Risk

Pertinent when the VIX just hit low 10’s.

Michael Lebowitz says that there is a huge chasm between perceived risk (which if you go by VIX is 0) and reality. He like many others blames the Fed. It should be noted that hes selling “Financial Survival Guides” here. That should clue us in on what is to come in this note…

First, he includes a great quote from Chris Cole of Artemis:

“(volatility) is the difference in the world as we imagine it to be and the world that actually exists.”

The author then goes on to say that implied volatility “has been abnormally low more often than not” since 2008. “Currently implied volatility is at a level that has only been experienced 0.22% of the time since 1990 and is almost half of its longer term average.”

My issue with this is that implied volatility is the estimated volatility of the underlying price. You cannot just say “low” implied volatility. It has to be in relation to something – in this case implied (estimated) volatility has to be compared to realized (actual) volatility.

Here is their VIX chart:

Lets use the last 12 months as an example. Realized volatility is ~9%. Thats under the red line that he draws on the chart above.

This chart shows more:

My point is you can’t just say “implied vol is abnormally low” you have to compare it to realized.

Second, you could also easily make the case the markets in 1990 were totally different than they are now, for better or worse. For one, VIX options didn’t start trading until 2006. Markets are now all electronic and connected globally. Information spreads like never before. Dodd Frank, CCAR and the like have changed the risks banks can take, this is particularly an issue for hedging as they are required to have risk hedged in the event of a 20-30% equity market moved.

The reasons the author sites for this “low implied”:

  • The Fed & its easy money
  • Corporate buybacks
  • Volatility Trading
  • “Passive Mentality”

Strangely he mentions the falling dominoes the same day Martin Armstrong did. Coincidence? Someone copied someone…. I suppose his conclusion is to expect a major volatility event but he just says:

“When the entirety of the current situation begins to more fully reveal itself, investors are likely to find that the difference between esoteric measures of implied volatility and their very tangible perception of reality could not be more different.”

I think to find out how to hedge this coming cataclysm you have to sign up for their newsletter.


Remember – Volatility Mean Reverts

Its something everyone loves to say when the VIX is  at 20 or 30, heck even 15. Yesterday we hit lows in volatility not seen since 2007.

The spread between realized volatility (SPX realized is ~7) and 3 month SPX implied has come in quite a bit as per Bloomberg. In April realized was ~7 but implied was ~12. So from that standpoint, volatility is “cheaper” now than its been over the last few months.

Maybe its time to think about unwinding that short vol trade…

VIX lows