A lack of fear in the volatility index

optionMONSTER

Just as it seems that everyone is afraid of falling off the "fiscal cliff," the VIX doesn't appear to be backing that assumption.

The CBOE Volatility Index dipped below 16 yesterday for the first time in about a month. It hasn't been above 20, the index's long-term average since a quick peak above that in late July, and it hasn't been above 30 in about a year. Many are wondering why the VIX isn't higher and why it isn't reacting to the continued drop in the S&P 500 and the fear of the fiscal cliff.

First of all, there are times when a VIX of 16 or 17 is considered high and times when it is viewed as low. Back in early October when the VIX broke above 16, it was quite high when compared to actual volatility , which was below 10 percent. And almost all of that real volatility had come from big moves up in the market, not down.

So that 16 reading reflected expectations of increased volatility. The VIX futures at that time were also carrying sizable premiums, further showing expectations of increased volatility.

Now, however, we find ourselves in a very different environment. The VIX again pushed up through 16 this morning, but the S&P 500 is about 100 points lower. With that alone, we would expect the VIX to be higher.

While we were looking forward to the election a month ago, we are now facing the fiscal cliff, which offers a much greater opportunity for a bad, " fat tail " outcome--another factor that we would expect to have the VIX higher.

And the actual volatility is higher now as well. The 30-day historical volatility is at a three-month high, and the 10-day reading is up above 16 percent. This means that there is no volatility premium priced into the VIX, so it is clear that the index is definitely low.

What question that remains, of course, is why. The main thing I can say is that, while there might be plenty of talk about the fiscal cliff, there is not a lot of hedging going on. Some will say that all of the recent action in the VIX options and futures, as well as in SPY and SPX puts, means that everyone is already hedged. But I have never seen that argument work.

So maybe people aren't as worried about the fiscal cliff as the media would have us believe. Maybe they believe that the government will come through or that the consequences are already priced into the recent market decline.

Or maybe they actually are worried but not doing anything about it, as a recent institutional survey suggested. We encountered a similar situation with the debt debacle.

From my perspective, this is another case of the market mispricing risk. The market will very likely go up if a compromise is reached, but I don't see a runaway bull phase in our future. Alternatively, if things go south, they could do so in a dramatic fashion.

So volatility may not be "cheap" here, but it could be viewed as such in retrospect if we do go off that cliff. So getting long volatility is a good idea here, and the easiest way to do so is to buy puts in equity indexes and ETFs.

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Nov. 14.)

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