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What's the "Right" Level for the VIX?

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The equity markets have been trending steadily higher so far in 2019, and the market’s “fear gauge” – the CBOE Volatility Index or VIX, for short – has been declining. The VIX last peaked during the height of the December selloff.

In general, the VIX increases quickly when equity prices decline and ebbs when prices are rising. Its current equilibrium level seems to be much closer to long term historical averages and higher than it has been over the last few years.

For several years, trading in VIX derivatives seems to have held the index artificially low. A wide range of traders from small retail investors to relatively sophisticated professional shops found the apparent easy money in the VIX irresistible. They shorted the VIX every time it rose using futures, options and inverse ETFs/ETNs and profited handsomely…for a while.

Huge spikes in volatility during a brief selloff in the spring of 2018 wiped out most of these traders. We documented that effect when VIX trading profits started showing up on big banks’ quarterly reports.

Many traders suffered losses in excess of the value of their accounts, especially those who were using leveraged ETNs, leaving their brokerage and clearing firms with significant debts.

Ultimately, there’s not much difference between being short the VIX and being short equity index options. Both involve significant risk.

Big trading desks that had the patience and foresight to stay long volatility - knowing that it would spike sooner or later - cleaned up.

Anyone employing the VIX-selling strategy who survived the Spring explosion was almost certainly finished off when the VIX spiked again at the end of 2018.

Short volatility strategies tend to blow up eventually. Though they appear to work for a while, but practitioners are really borrowing the money from the markets rather than actually earning it.  When it comes time to pay the debt back, it’s usually very painful.

Here’s the story of another one…

While that trade was working in 2013-2018, the effect of all that money available to sell volatility had a depressive effect on the VIX. Other than a few short-lived increases, the index stayed in the low double digits for long stretches.

Over the long term, the observed volatility of the S&P 500 is between 14-16% - depending on the length of the period used for the calculation - and the implied volatility of options tends to be 1-2% higher than observed actual volatility.

That would mean the equilibrium level for the VIX is 15-18%, which is just below where the VIX index closed on Wednesday.

Now that those chasing easy profits have been flushed from the markets, the VIX seems to be floating back to more normal levels.

If the markets are lulled into complacency during this rally, it’s possible that the VIX may once again trend lower, but beware of strategies that seek to profit from those declines. They tend to be fool’s gold.

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