Wednesday, January 21, 2009

SPX realized Vol (10 day) and VIX

Be careful wedding VIX with a directional bias in SPX.
By definition volatility can be bi-directional with those trading the gamma being long SPX options able to make money if the market moves up or down as they reset their deltas.
In fact, vol regimes are raised with a long term bull market, not bull, while short dated vol spikes up it seems only with a bear move given the impact of the correlation of the sum of the vol of all the underlying stocks in the index. This is how most think VIX will always behave.
But, while the VIX is trading down given the strong up move today, the vega of the underlying names along with the likely correlation staying unchanged or rising in the large bull move, and also given the reality of a large move in regards to delta hedging - all this makes for large loses in option trading today.
Also, while a bull market in the long run results in volatility rising in general, that has limits of being true from, say, low teens to high 20s but anything above 30 vol indicates stress, period. Stress from either hedgers not making money as the actual or realized volatility results in ill timed resetting of the delta exposure. Losses all around. Therefore while a bull market raises vol in general, once a certain level on vol is passed, increased vol reverts back to being a bearish indicator.
So, the VIX trades as most expect the VIX to move given the 30+ up move in SPX. But note how during this crisis how realized volatility - in this case the volatility the SPX showed in rolling 10 day periods - realized volatility was very prescient or at least concurrent with how the VIX ended trading.
I think for the up trade today and the drop in the VIX to give me comfort, I want to see it developing in a more steady fashion and showing a steady drop in realized volatility as well.
Do not think we are out of the woods yet by any means.

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