Get Your Volatility Signals Right

There have been worries for the last few months about low levels of volatility. These have recently gone up a notch, with expectations for future volatility that are rather high. It’s like someone telling you, “This bridge is perfectly safe, but it could get dangerous at any instant, and collapse before you have time to get off.” That’s not what most people consider “safe.”

To understand how all this is playing out in the markets, first consider that the CBOE Volatility Index, or VIX, is the implied volatility of the S&P 500 Index. Then there’s the CBOE VVIX Index, which is the implied volatility of the VIX. The idea is that although the market expects low volatility in the S&P 500 over the next 30 days, it expects big moves in volatility. That’s based on the high ratio between the VVIX and the VIX, which has averaged 8.0 since the beginning of May. Other than the last year, the ratio has only been above 8.0 on 10 scattered days from October 2006 to January 2007, when the first cracks in the subprime mortgage market were becoming obvious. The average value up to a year ago was 4.8.