I have to admit, while I have been expecting the VIX to return to normalcy, I have been shocked at the speed at which it moved down. I have been writing for some time that I expect the VIX to fall down and fall down hard. We wrote about how in December we were expecting the VIX to dive based on how the futures were priced. Even so, I didn’t think VIX would be threatening 20 by the first week of January.
Livevol(R) Pro (www.livevol.com)
Currently, SPX option IV (LiveVol’s equivalent of the VIX) is trading at about a 6% premium to realized volatility (which is just over 12%, the white line). This is far greater than the historical assumption of 2% that most believe is priced into options. So what does this mean? One of 3 things:
1. The VIX is going to stay the same and realized volatility is going to uptick incrementally by 2-4%
2. The VIX is going to drop another 2-4%
3. The two will meet in the middle with SPX moving a little bit more and the VIX dropping.
For the VIX to really catch a rally, we would need to see the market move more than the index is currently pricing in for several days in a row. Right now, the index assumes the SPX will move about 1.25% a day, we would need the SPX to move more like 2% in order for us to make a big move over 25 anytime soon.
So what has caused this massive drop in SPX option implied volatility? A massive drop in realized volatility. Let’s remember, for the VIX to justify being over 30%, the S&P 500 needs to move about 1.9% a day in realized volatility. When was the last time we saw the SPX move that much? December 20th…over 2 weeks ago! In fact, looking at realized volatility over the last 10 days, the VIX could be dropping a lot lower next week:
Traders have very short memories, It was less than half a decade ago that the VIX was trading near 12% and the thought of a VIX of 20 seemed downright shocking. If the market does indeed rally, that 2% move needed for the VIX to pop to 30 is going to become harder and harder to get to. Keep an eye on earnings this week, if they are positive, the market is primed to break out higher and should break 1300.00.