Happy VIX Days From Here

• Posted by Adam Warner
• on February 8th, 2011

This, from MKM Partners

A defining characteristic of equity implied volatility is its tendency to mean revert. With the CBOE SPX Volatility Index (VIX, 15.93) having been sustained below 20 for more than two months, we believe reversion through the long-term mean is inevitable. As a result, we see short-term risk as becoming increasingly asymmetric and continue to recommend that favorable option market dynamics be exploited.

Spot VIX declined through 20 on December 2, 2011, and at that time we argued that the displacement of VIX to 45 earlier in 2010 coupled with a two-month consolidative phase between October and November would apply significant downward force into the volatility wave trough. Our expectation at the time was that VIX would be sustained under 20 for around two months and trough close to the bottom of the 15-18 range that had been established beginning in July 2007, while the S&P 500 Index gained in the neighborhood of 10% based on the precedent of the March-April 2010 period.

As the two-month anniversary of VIX being sustained under 20 approached, we discussed on January 18 our view that the criteria for a wave trough had been met and suggested that, within our framework, this equated to an increasing state of disequilibrium for U.S. equity markets. As a result, we recommended that favorable volatility dynamics – namely low implied volatility and flat skew – be exploited to reduce risk following what was then a 23% appreciation of the SPX from the August 2010 low. Over the subsequent two weeks, VIX ran up sharply to just above 20 on news of unrest in Egypt, then rolled over to close Friday just below the 16 level while the SPX managed to grind another 1.2% higher.

Then, last week, sub-20 readings for spot VIX surpassed the March-April 2010 period and all prior troughs since the current high-volatility regime began in July 2007. Naturally, this has prompted questions about any change to our view. For example, some wondered if unprecedented U.S. monetary policy has distorted the current volatility cycle, shortening it relative to the 5.5-year average duration of regimes over the last 30 years. In our view, this is unlikely. We think it as improbable that the aftermath of the global financial crisis and deep U.S. recession is more psychologically benign than recovery periods following what were relatively shallow economic troughs in March 1991 and November 2001.

As a result, our base case remains that the current high-volatility cycle returns to its July 2007-August 2008 pattern when spot VIX was bound between 15 and 30, an outcome that may feel somewhat moderate relative to the volatility events over the last two years. Still, if our framework holds, implied volatility will revert through its long-term mean just above 20, coincident with a pullback in the U.S. equity market. Following a 25% gain in SPX since late August 2010, unrealized gains abound. Low implied volatility and flat skew afford the opportunity to hedge these gains or replicate long exposure synthetically using options to reduce risk. With the next volatility event still on the horizon, in our view, this is not a time to accept complacency.

I would agree that we’re a bit overdue for a volatility *correction*. And I currently pay decay, first time I’ve had that on in eons. I’m net long options gamma in a handful of individual names and not short enough index options premium to offset it. But (big but)….its VERY tough to time a volatility explosion. You generally get one or two per year. Our last big one was in May, and we’ve had pretty modest and quick one’s in November and a couple weeks ago. That being said, there’s no magic time frame for the next one, and no magic VIX low that will ignite it.

So don’t get carried away anticipating it. Time costs money in options world.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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