ST Note - VIX

According to the white paper from CBOE, the volatility Index (VIX) measures 30-day expected (implied) volatility of the S&P 500 Index options and the components of the VIX Index are near- and next-term put and call options with more than 23 days and less than 37 days to expiration. The index calculation is a complicated one but VIX is often used not only as a barometer for market uncertainty but also serves as an underlying of VIX futures and options for both hedging market risk and speculation of directional volatility. One of the practical ways of using VIX numbers is to convert it to work out the implied trading range of S&P 500. For example, assuming S&P 500 at 4,200 and VIX 20 meaning annualised % with one standard deviation of normal distribution, so divide it by square root of 52 then multiplying by 4,200 equates to 116 points either way or 4,084 - 4,316 over the next week.  

There are also other similar alternatives such as SPX or SPY options but without going into too much details, VIX options have higher implied volatilities across the curves meaning bigger swings given the underlying is calculated from the option prices of SPX but also the trade can be done with smaller notional amount providing flexibility. Based on ATM options expiring 17 Aug, VIX is about 5.6 times higher than SPX indicating if S&P500 moves down by 1% then VIX would rise by 5.6% so this ratio can be applied when working out the number of contracts to trade VIX options while also the correlation of underlying isn’t exactly 1. Trading VIX futures directly is also another way to buy/long volatility however this would be based on contract size 1000 x index rather than VIX option’s 100 times and given the current term structure shows contango, premium needs to be taken into account as you go further out in the expiry of the futures contract.

Last two alternatives could be either long USD or short credit for risk-off set ups but USD has lower correlation to SPX (e.g. AUDUDS with 0.6) and trading credit spread isn’t that practical as it requires short high yield corporate bond (HYG or JNK) / long treasury (ZNU2) and the spread is already has widened to 470 bps although it has come off from recent high 600 bps.

This week VIX closed below 20 for the first time since 4 Apr falling from Jun high 35 while S&P 500 rallied 16% to reach 4,200 in the anticipation of inflation peaking in addition to buy-the-fact post earnings moves and this month it has remained below 200DMA 24.6. During bull market run last year, VIX found support area at 15 so current level near 20 may seem like it could decline further before finding bottom but it is quite clear to see that the sensitivity of VIX to 10 year treasury yield has been high then this month divergence started to exist coinciding with some of the key inflation expectation related asset classes began reversal last two weeks or so. The latest VIX option trading volume was above 20d ave (561k vs 426k) with calls more than doubling puts and unsurprisingly the implied volatility of VIX option is higher for calls as you go further out of the money. Inflation level or expectations – despite recent drop from 9.1% to 8.5% - that mainly would determine the hawkishness of Fed for next rate hikes, should continue to remain as a downside risk for S&P500 that also would trigger potential spike in VIX that has been descending for eight consecutive weeks.