The Option Pit VIX Traffic Light is Yellow: Volatility Is Going To Move.

Hey Traders,

The VIX has broken its streak!

This morning saw the VIX gap lower below 20 …

But with the S&P 500 rallying (Ticker: SPX), I would have actually expected to see the VIX drop off even harder than it has.

So why is the VIX staying elevated?

It is because of the VIX itself.

This morning’s move lower is not actually reflective of lower volatility in the market.

Instead, it has more to do with the way the VIX itself is calculated.

The VIX measures implied volatility (IV) in S&P 500 options. 

However, for the VIX, not all options are equal …

The VIX is vega weighted, so it weights at-the-money (ATM) options heavier than out-of-the-money (OTM) or in-the-money (ITM) options.

This has to do with the way the SPX skew curve is set up.

Note the steeper curve and higher volatility on the lower strikes.

As you move up the curve (so as the S&P 500 rises, and the weighted ATM options move to the right) you will naturally see the VIX fall, because the ATM options it is weighting are lower on the curve.

This happens even when actual volatility does not move very much … which is what is happening right now.

So when the market rallies, and the skew curve does not move, the VIX is looking at the lower volatility ATM options, but actual volatility is not falling.

In fact, it is even possible to see real volatility go UP, and the VIX will DROP because of how ATM options are weighted.

So with today’s rally, we aren’t seeing the VIX fall very much. 

And this is because volatility is down less than 0.5 points strike-to-strike.

That is a part of why we are seeing continued strength in VIX futures, and why the VIX is holding up so well.

With today’s market rally, I would actually expect to see the VIX down even MORE than it already is …

It is maintaining near 19.5 so far today, but I would usually expect to see it closer to 18.

The big volatility move we have seen over the last several days is still messing with overall markets, and with the VIX itself.

I think we will continue to see volatility, which is why the Option Pit VIX Traffic Light is yellow.

Your Only Option,

Mark Sebastian