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All the focus on the CBOE Volatility Index (VIX) the past few years has made us all lose sight of the fact that it merely indexes the volatility of actual options — S&P 500 (SPX) options, of normalized 30-day duration.
When you own an actual option, volatility is, of course, a vital variable in pricing. But so is time decay. The VIX calculation assumes all time is created equal. A day in March equals a day in September equals a day in June equals … well, any day.
In real life, not every day of an option’s life is equal. The simplest example is that a day has less value for an option if the market is closed.
Suppose you compared two identical options with the same underlying, same strike, same volatility picture, and same calendar time until expiration, we’ll say 14 days. But here’s the one difference: Option number one has 14 days of which the market is only open on four of them. Option number two has 14 days, of which the market is open 10 of them.
Quite clearly, you’d pay more for option number two. More trading days equals more price points, which equals more opportunities to trade stock against the option, or sell the option, or whatever. If you pay more for that option, it translates into a higher volatility for that option, because remember that every factor that actually goes into the volatility calculation is equal.
Instead of a closed market, let’s just say it’s a slow market, like, say, what we anticipate the next two weeks as we head into the July 4th holiday. You clearly want to pay less for “time” under those circumstances than a typical two-week stretch. This has the effect of lowering the markets on actual SPX options, which, in turn, lowers the implied volatility calculation, which is, in turn, the VIX. Hence a bit of the heaviness we’ve seen.
But is it really heavy? Well, yes, it’s real, as the VIX is defined. A better question, though, is if we should read much into it.
My short answer is no. You want to look for “abnormal” when you look at the VIX. The desire not to overpay for options decay is perfectly normal. It does not speak much about future volatility assumptions.
For that you might want to look at VIX futures, or the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX), for the next couple weeks. As of now, VIX futures trade at premiums to the VIX. This will likely persist for the cycle. If you see longer-dated VIX futures give up that premium, then we can talk about complacency. But, for now, let’s just call this seasonal bid-lowering.
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