The VIX Pop: Bullish On the Margins?

Want more signs that the volatility market got a bit extended in this latest oil/Russia/Fed scare? I bring you derivatives of derivatives, via Barron's:

"But Mandy Xu, an equity derivatives strategist at Credit Suisse, notes that a complex measure of the excitedness of VIX behavior itself almost tripled last week to near its all-time high. She's looking specifically at the 'implied volatility' of the VIX, which rose to 139 last week from 57.

It's a kind of a Through the Looking-Glass market indicator -- the VIX measures expected swings in the S&P 500, but this other index, the CBOE VVIX Index, tracks prices of options on the volatility index itself. It measures, quite literally, the volatility of volatility.

Sounds like an exercise in navel-gazing, but some see in the sudden ramp in VVIX as a sign that high-yield bonds (selling off for months) and stocks (still near all-time highs) might be about to reconcile their differences. Lots of people spend time trying to squeeze market signals from discrepancies in volatility metrics."

Ah, the CBOE VIX Volatility Index (VVIX), voted the most confusing gauge ever by … well, everyone, if they really voted on such a thing. It proxies the implied volatility of options on the CBOE Volatility Index (VIX) itself. It uses the VIX methodology to index the implied volatility of said options.

VIX options are, of course, options on VIX futures, not VIX itself. Futures themselves virtually always trade at a premium to VIX (except when VIX pops, like this past week). VIX futures options trade at a very steep positive skew -- the higher the strike, the higher the implied volatility. That's another way of saying that the out-of-the-money VIX calls trade very high in implied volatility terms. And that makes perfect sense. The lion's share of order flow in VIX consists of speculation on cheap-dollar VIX calls. There's some speculation. It's a bit of a lottery ticket on VIX pops. And there's some portfolio hedging going on. As Barron's alludes to, perhaps there's hedging going on vs. bond portfolios as well.

So, when VIX goes up, VVIX absolutely explodes. Part of that pop is self-fulfilling. As VIX lifts, higher-vol. VIX strikes carry more weight in the VVIX calculation. But, part of that pop is simply greater demand for VIX paper. And certainly when you see VVIX lift this much this quickly, there's plenty of "real" sentiment expressed in that lift. Of course, it all depends on how you view VIX, and fear in general. If you view it as a contrary tell, then you should view VVIX in the same light. And since I view it through that contrary lens, VVIX is certainly consistent with an already overbought VIX, and bullish on the margins in my humble opinion.

It's important to note that another vol gauge, the iPath S&P 500 VIX Short-Term Futures ETN (VXX), has not gotten quite as extended. Dollar-weighted volume spiked in this latest pop, but it's considerably lower than levels from the October VIX pop. It is higher than July VIX pop levels, though, so we'll call this an "eh." All in all, I'd say the vol complex got extended, but not alarmingly so; modestly bullish on the margins, in my humble opinion.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.