The VIX is receding, finally
From technical perspective the VIX looks poised to decline. It has already traded at levels today below its 30 day moving average, as well as the 30 and 90 day realized volatility for the S&P 500.
If you read our work regularly, you know that we watch the VIX closely. Since the second week of October, we have viewed the wild gyrations of the “fear index” as the volatility equivalent of a short squeeze, where those very few arbitrageurs left in the options markets with capital have had the heads of the many without it caught in a vise.
The models employed by the designers of the VIX assumed that implied volatility could be extrapolated by backing out the known factors (maturity, difference between the strike and underlying) and a series of assumptions (e.g. cost of funding). The implicit assumption of this methodology is that the option premium reflects the ability of a trader to execute a delta hedge in the underlying market simultaneous to trading the option. Obviously, if a trader cannot execute a hedge due to choppy markets (or say, a short sale ban) or if he has no funding available, he will not be able to manage risk efficiently. If the trader is a market maker, and therefore OBLIGATED to show a price, he will show one with a premium that is either so richly priced he has a high degree of confidence that the premium will offset any loss or it will simply discourage anyone from trading with him (more often the preferred outcome).
As such, it is our opinion that the VIX here is still not really measuring equity investor sentiment, even though it has come down by more than 40 points from its high. Instead the VIX appears to remain more a measure of liquidity in the risk markets, which have been severely disrupted.
The decline of the VIX towards levels which appear more “normal” compared to longer term historical averages is inevitable. As a former colleague of mine recently commented “It would be nearly impossible for realized volatility to persist above 50 forever. At that level everything would hit zero eventually and there would be no more market.”