By: D. David Jilek, RMA, CAIA®
On June 2, the Chicago Board Options Exchange Volatility Index® or VIX1 reached a year-to-date closing low of 9.75, just above its all-time low of 9.31 in December 1993. While some have expressed a view that widespread volatility selling2 has driven volatility to “artificially” low levels, we do not share this view. We believe that low volatility is driven by other factors.
Recent research from Barclay’s Equity Research3 examined the effect of volatility selling from multiple perspectives and determined that volatility selling through instruments such as index options, VIX futures and variance swaps is not likely contributing to low volatility. This is consistent with our own research.
In fact, the lowest volatility periods in equity market history occurred before volatility selling was a widespread technique, including 1995 and 2006, when VIX was persistently around 12 and reached a low point below 10.5. In addition, recent low volatility isn’t confined to the U.S. stock market. It’s a global phenomenon, existing even in markets where access to volatility selling instruments and techniques is limited.
Fundamental and Structural Factors Are Dampening Volatility
Our view is that implied volatility4 is low because realized volatility5 is low. Further, key fundamental and structural reasons are behind low realized volatility. These range from the simple – e.g. an improving global economic backdrop, strong earnings growth and confidence in central bank policies – to the more subtle and complex – e.g. increased indexation, algorithmic trading increasing as a percentage of overall trading volume and low cross-sectional stock correlation.
Extended periods of well below average volatility have existed in the past and have lasted for months or even years. Given the fundamental and structural volatility dampeners present today, the current low volatility is not very surprising or unprecedented, despite distinct external market factors that could potentially trigger higher volatility.
How Low Can It Go?
VIX could go even lower than it is today. The spread6 between implied and realized volatility is larger than normal (5 points as of June 2, 2017, as compared to a more typical spread of less than 4 points). History suggests both realized volatility and VIX could fall meaningfully below current levels since the lowest quarter of realized volatility for the S&P 500 Index (USD) was an annualized standard deviation of just 3.7% in the first quarter of 1964. Although implied volatility typically exceeds realized volatility, if current realized volatility dropped near all-time lows, VIX could easily set a new record low.
How Long May the Quiet Last?
There is no way to know how much time will pass until the market experiences higher volatility. Once VIX reached its low point during past periods of low volatility, it has historically taken approximately three months to nearly a year for VIX to climb back to its long-term average of 20 and even longer for a significant downside event to materialize that causes VIX to spike above 30. This historical evidence suggests we could be in a low volatility environment for a while yet.
1 The CBOE Volatility Index (the VIX) measures expected future (30-day) volatility of the S&P 500® Index and is derived from the prices of S&P 500® Index options. An option is a contract that gives its owner the right, but not the obligation, to buy or sell a specified amount of an underlying security at a specified price within a specified time.
2 Volatility selling refers to the use of derivatives in the attempt to monetize the implied volatility priced into the S&P 500® Index options market.
3 Index Volatility Weekly, “Is volatility selling contributing to low volatility?”, Barclays Equity Research, January 25, 2017.
4 Implied volatility is the expected future volatility of a index’s or security’s price over a specific period of time.
5 Realized volatility, or historical volatility, refers to an estimate of an index’s or security’s price variation in the past, usually expressed as a standard deviation.
6 Here, the term spread refers to the difference between two volatility measurements.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above as of June 2, 2017, may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
All Investments carry risk, including risk of loss.