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.

SPY IV vs RV

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.

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