Here are some observations about volatility and market conditions.
1. Option implied volatility is not especially high. With all the noise in the markets, you might think that options prices have baked in a lot of downside risk. They haven’t. One month SPX historical volatility is about 18%, and one month at the money implied volatility is closer to 20%. If we add in out of the money skew, VIX-style, we get an estimate of 23.5%. That ratio of implied to historical – 1.30 – is not a level we associate with excessively high options prices. The SPX volatility risk premium was much higher in April and May of this year, in fact, and was above 2.0 for quite some time in 2011.
1M Major Asset Volatility Risk Premium. Source: Condor Options
2. The Europe / US volatility gap is still in place. The following chart shows the July VIX futures and July VSTOXX futures – the latter is a VIX-style equivalent on the European STOXX 50 index. We’ve compared these products in previous articles, and the key thing to know is that, while these products typically trade in close sympathy with one another (consistent with the high historical correlation of U.S. and European equity prices and realized volatility), in 2012 we’ve seen a major gap open up with VIX products trading lower than their VSTOXX counterparts. At the close on Friday, June 8, these July volatility futures were about 9 points apart. At the close on Monday, that gap had narrowed somewhat to 6.8.
July VIX and VSTOXX Futures. Source: Interactive Brokers
3. SPX component correlation is rising. We’re nowhere near levels reached in previous years, but the higher this estimate goes, the less healthy the market is.
S&P 500 Average 1M Stock Correlation. Source: Thomson Reuters Datastream
4. I have not (yet) won the VIX < 20 / VIX > 30 bet. On June 1st, with VIX around 26, I mentioned on Twitter to Mark and Russell that I thought the VIX would close below 20 before it closed above 30. On Monday, VIX opened at 19.87, and quoted as low as 19.63 in those first few minutes; as stocks sold off, VIX climbed higher and closed at 23.56, snatching sweet victory from my grasp. This is mostly tongue-in-cheek: I’m not massively long VIX 20 puts or anything. In our client portfolios, we’ve actually been lightening up our total exposure for the last month or so. If I had to make a new prediction right now, I’d say the most likely scenario over the next month is of a VIX bouncing around between 20 and 30 for the sole purpose of aggravating everyone. I don’t often trade front month VIX futures except to hedge long equity exposure or against short straddles. If you want to speculate, look further out on the curve.
Disclosure: At the time of publication, Jared Woodard held positions in VIX futures and options and SPX options.