VIX-Piracy Time!

• Posted by Adam Warner
• on December 19th, 2010

Zerohedge chimes in on our beloved VIX. Since he has about 4 billion times my audience, I feel some sort of civic duty to elaborate on a few of his points.

On April 15, the VIX contango hit its heretofore steepest of the year. What happened immediately afterward was a peak in the market followed by a plunge, and the flash crash, coupled with a massive flattening of the curve.

OK, so far so good. I’m not sure how you define “steepest”, but it was certainly up there back then. Keep in mind options volatility moves relatively fast when its measuring short time frames, so any abrupt decline in VIX will virtually always steepen the curve at first. Over time, the curve flattens one way or another, either by near term and *spot* lifting or the longer dated VIX futures drifting. In May of course it was the former, but its far from guaranteed to resolve that way every single time.

What also happened was unprecedented pain for Goldman, which had been pushing the Variance Swap so hard, it ended up with residual inventory on its flow (but not prop) desk, resulting in a major loss for the firm once the curve flattened. Yet anyone who thought that Goldman’s Delta One prop desk would ever lose money, should just look at today’s ridiculous VIX curve which is now trading at a steepness unseen in years.

Didn’t he just say the April 15th VIX curve was the steepest of the year? But now its at steepness unseen in years. OK.

More than obviously someone is pushing very hard on the spot, while ignoring or buying the mid and long end.

Here’s where he leaves the yard. There’s no *spot* to push. VIX simply indexes SPX options. If traders collectively expect a couple slow weeks ahead, they simply lower their bids for nearer dated options. If they notice that realized volatility in SPX looking backwards 10 days is 5 (yes, 5) they really don’t want to pay up. Remember always that time is money on options.  VIX right now essentially prices volatility of Jan. SPX options. On Friday they had 35 days to expiration. But the first 17 of those days are either weekends, holiday’s, or slow trading sessions between holidays. Its far from shocking that options prices would decline ahead of that.

And they’re not buying the mid to long end. Its simply not declining as swiftly as nearer end. Nor should it.

And as we expected earlier this week, the only driver for stocks right now is what is happening in VIX land, driven by the near record open interest, which is now so disconnected from the volatility in all other assets (FX, bonds), it is beyond deplorable. Yet perfectly expected: with no volume, one market maker can do with the market entirely as they see fit.

He has a better point here. Volatility should flow across asset classes. Bond and currency volatility has not tanked. Perhaps stock volatility does perk back up again. I just wouldn’t expect to see it in the next couple weeks. Its not so much a conspiracy though as it is a calendar.

If you cut away the tin foil stuff and the shaky VIX references, he does make a valid point here. Stock volatility will not ultimately disconnect. More likely than not, VIX is troughing here.

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