The VIX index, which measures market volatility, is actually much higher than the current levels being demonstrated in the S&P 500 index, according to S&P Dow Jones Indices.
Tim Edwards, director of index investment strategy at the company, said the VIX’s current measure of roughly 11.5 was nearly double the 6% annualised volatility actually registered by the S&P 500.
“Although the VIX is a measure of implied, rather than actual, volatility, it still ought somehow to be anchored in realised volatility data,” Edwards said.
“The VIX is currently much, much higher than realized volatility. One interpretation of this is that the market ‘expects’ next month’s volatility to be nearly double what we’ve seen recently. Moreover, the futures market is pricing in an expected gain in the VIX to around 17 by March 2015—nearly triple the current level of realized volatility.”
Edwards argued that the discrepancy between the two measures was down to the VIX pricing in tail risks that the S&P 500 was not. “The mere possibility of tail events—invisible in current equity valuations—provides the VIX with a different perspective,” he said.
Janet Yellen, chair of the US Federal Reserve, warned last month that ultra-low volatility in markets could “induce risk-taking behaviour that entails excessive buildup in leverage or maturity extension”, which could in turn pose risks to financial stability.
But while the discrepancy between the S&P’s volatility and VIX’s reading exists, Edwards warned that strategies for making money remained risky and “exclusive to the courageous”.
“Selling S&P 500 put and/or call options can realise a profit if volatility proves less than expected, as can taking short positions in either VIX futures or in related exchange-traded products,” he said. But “the risks of such strategies are far from symmetric”, he added: Any unforeseen event to introduce volatility to the market could cause massive losses for any investors who short VIX futures.
Edwards concluded: “Even when profit is possible, or highly likely, dramatic risks remain. Selling volatility remains a strategy exclusive to the courageous. Perhaps that is one reason why the Vix is so high.”
Related content: Smart Beta Winning Fans as Volatility Fears Escalate & Dunatov: Volatility Measure ‘Dangerous’ for Long-Term Investors