The Option Pit VIX Traffic Light Is Red: Volatility Is Likely to Drop.

Hey Traders,

Now that the VIX is finally under 20, it seems to be stuck hanging out around the 17 handle.

But for how long?

With the market going up … surely it is time for the VIX to continue its journey lower, right?

The answer is … maybe.

We could be looking at a sub-15 VIX in the days ahead …

But it is not a sure thing.

What are we looking at that points to a sub-15 VIX?

There are a few things.

For one, the S&P 500 (Ticker: SPX) continues to look strong.

With the SPX and VIX having a negative correlation – when one goes up, the other tends to go down – a strong SPX could put downward pressure on VIX.

We are also seeing the market start to breathe a sigh of relief now that we are realizing the latest COVID variant has relatively lighter symptoms than previous variants. This means the markets are not as fearful of an extended economic shutdown, and traders are looking for reopening efforts to continue to ramp up.

The VIX also has steep skew right now … indicating there is a strong demand for out-of-the-money puts. 

While a strong demand for puts may sound like a vote against a lower VIX, it is not.

Think about it … if traders were really nervous , we would see a stronger demand for at-the-money or near-the-money puts … puts with meat on their bones.

But a higher demand for crash protection puts tells me traders are buying these puts more as a  “just in case” protection, not because they really think the market is going to crash.

However, it is not a given that the VIX will be touching near post-pandemic lows …

And there are still some signs that make me think we may not see the VIX take a nosedive as soon as we might hope.

First, we have high option volumes …

When traders are anticipating further moves out of the VIX, they tend to scurry to position themselves.

High volume tells me that traders are still looking for movement.

There is also still fear in the market. Even with the VIX slowly slipping lower, and omicron not being quite the disaster it was initially feared, there is still definitely plenty keeping traders on edge …

Record-high inflation, a gridlocked Congress, COVID is still not over, supply chain backups, labor shortages, poor market breadth, possible rate hikes .. you name it.

Also, if the aforementioned steep skew stays steep … that could tell me that traders are more nervous than their crash protection puts might initially indicate … if they choose to keep these positions on, and continue to add to their hedges, this might keep the VIX elevated due to the heightened demand.

Finally, looking at SPX realized volatility (actual movement) versus implied volatility (IV, anticipated movement) … implied volatility actually sits below realized volatility.

This tells me that even with the steep skew and nervous traders, actual movement is actually outpacing anticipated movement.

If this trend continues, we could see implied volatility move higher to meet this realized vol …

Which would work to drive the VIX (which measures SPX IV) higher.

The first few trading days of the year will give us more insight into what traders are thinking …

So I will be keeping a close eye on the VIX pits in the days ahead.

Your Only Option,

Mark Sebastian