The Simplest Skew Illustration I Can Think Of

• Posted by Adam Warner
• on May 28th, 2010

OK, the VIX indexes SPX options volatility for a hypothetical 30 day option. SPY options essentially mirror SPX options in volatility, so let’s use them. Why? Because I trade SPY and not SPX.

Now let’s say we make the VIX really simple. We’ll say it’s just the implied volatility of the nearest to the money June option.

On Wednesday that was the 107′s, and they closed at a 32 volatility. That’s the VIX close for Wednesday on our system. Meanwhile the 111 line closed at about a 26 volatility.

Then on Thursday the market roared. The 107 line declined in volatility to 29. But that’s not involved in our calculation any more. The 111 line? A far from cosmic drop to 25. If you actually had a position in them, and nothing else, you barely noticed a change in implied volatility.

Our VIX however? It got slammed, from 32 to 25. Yowza.

But as you can see, nothing all that cosmic happened in actual options. The 107 line (and in real life, all the now OTM puts) did see a decline in implied volatility. But it was generally in the 3-4 point range. Meanwhile the OTM (now nearer money) calls saw very modest drops.

Yet look at the VIX. Down 7 points.

This is somewhat exagerated, but not all that different than what happened in the actual VIX yesterday. It dropped 5.34. But if you look at the numbers, maybe 1/3 of that drop was an actual change in volatility assumptions. The other 2/3 was essentially a math exercise. Strikes that already traded at a lower implied volatility now have a greater weight in the VIX calculation. So ergo the large VIX drop.

This is an example of why I believe people make way too much of every VIX tweak. My background is as an options market maker. If I stood in the SPY crowd and traded all day, I’d barely notice any volatility drop, yet someone outside the field will see this indexed and go nuts with interpretations.

 

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