Calm before the storm? An analysis of the volatility markets

Source: Artemis Capital Management

The calm in volatility markets (realized and implied) since implementation of the recent wave of global stimulus has been nothing short of incredible.

The microstructure of daily VIX movement (defined as minute-by-minute vol-of-vol annualized) has fallen dramatically since implementation of the ECB’s LTRO program. Volatility-of-volatility microstructure is now calmer than at any point over the past six years of data.

The VIX index registered the lowest intra-day movement in history on January 11 with a daily high-low range of only 1.14%. The S&P 500 index has gained or lost only 0.46% a day in 2012 compared to 1.04% in 2011 representing the biggest reduction in eight decades going back to 1934 (shortly after Roosevelt devalued the dollar to end the Great Depression).

Volatility of VIX

Volatility markets are simultaneously calm on the surface and fearful underneath. Look at volatility one way and you see nothing but complacency with five year lows in the VIX index, but look at it from a slightly different angle you will see a furious bull market in fear. On August 17th the VIX index fell to the lowest level since the summer of 2007 generating significant media attention. Every time the VIX falls into the low-teens you get the same clichéd range of “volatility is cheap” and “now is a good time to hedge” sound bites from the financial media. Low spot-volatility does not mean cheap volatility. Volatility may be cosmetically low compared to historical averages but this ignores many important factors. For example, this past August it was more expensive to buy 1-year forward volatility with the VIX at 13.45 than it was one day after Lehman went bankrupt in September 2008 when the VIX was above 31. Think about that!

VIX futures curve