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The sharp decline in market volatility has directed a lot of attention to low readings in the
CBOE Volatility Index
. Given all of the plausible scenarios for market turmoil not that far in the future, traders have been wondering: Isn't VIX at least a tad underpriced? Nicholas Colas from ConvergEx responds:
"In practice, the VIX measures expected changes in stock prices over the next 30 days. That's it. It is heavily informed by recent actual volatility, as I noted. A VIX reading of 14 shouldn't make anyone, anywhere, feel more confident about what will come down the road in October or beyond. It is simply the relative assurance that the weather will be clear tomorrow." [via <a href="http://www.thereformedbroker.com/2012/08/20/the-truth-about-vix-shrinkage/" rel="nofollow">The Reformed Broker</a>]
So, just because VIX is low, it doesn't mean that the market is ignoring or is complacent about risks whose timing is more than 30 days out.
If you want to make the case for complacency, though, longer-dated options tell an interesting story. The attached chart shows 3-month S&P 500 VIX-style implied volatility, which is published under the ticker VXV. I've also plotted the long-term mean of this index, which is 27.55.
S&P 500 3M IV (VXV)
Source: Condor Options, CBOE
Unlike VIX, this estimate using longer-dated SPX options covers all of the scenarios that people are worried about: the end of the European summer vacation, the U.S. election, and the looming fiscal cliff.
Since 2007, the lowest value of this estimate was 17.43%, which is less than a point below the closing value on Friday. The standard responses to claims about volatility being too low are all true:
- Markets can stay quieter for longer than option buyers typically expect;
- When you consider the even lower levels of trailing stock index volatility, SPX options actually look overpriced in hindsight;
- There's nothing preventing implied volatility from marking new all-time lows.
However, investors should be aware that rock-bottom implied volatility is not only to be found in the VIX: Options are cheaply priced further out on the curve, too.