Last time, we talked about the convergence and divergence between the VIX and SKEW and what sort of information we could get from that. Today, let me introduce you to the VIX/VXV ratio combined with an application on the US Stock market.
But first, let’s start with the definitions of all the indexes:
– As a reminder, the ‘SKEW’ is an indicator that computes the implied volatility of the S&P500 from OTM the options and therefore ‘measures fat tails’ and investors fear.
– The VIX index, introduced in 1993 by the Chicago Board Options Exchange (CBOE), measures the 30-day volatility implied by the ATM S&P500 option prices. The components of the VIX are basically near/next – term put and call options.
– The VXV index (that you can also find in Bloomberg) is designed to be a constant measure of 3-month implied volatility of the S&P 500. It uses the same methodology and generalized formula as the VIX index.
If you are familiar with the term structure, investors and traders can use the historical data of the last two indexes (VIX and VXV) in order to gain a better understanding of the market’s expectations of the future volatility. As you can see it on the graph below, for the past few years (December 11 – June 14), the VIX/VXV ratio (in green) has been oscillating around 0.85 – 0.90 with a low of 0.71 (16-Mar-12) and a high of 1.0645 (02-Mar-14). The ratio has remained most of its time below 1.00, which is logical as the term structure should have an increasing concave shape (in theory). Basically, a ratio superior to one would mean that investors are more concerned about the near term fluctuations (usually a correction) of the S&P500 and often comes from an appreciation of the VIX due to market events such as FOMC meetings or companies’ earnings.
In the graph, we drew a white line which has (‘kinda’) acted as a support for the VIX-to-VXV ratio (around 0.82). However, when we look at the S&P500 chart (white/blue), we can see that most of the times that we hit this ‘imaginary’ resistance, the ratio rebounded and we either saw a stagnation or correction in the stock market.
For those who don’t agree with us concerning the application, they just to have to remember that the VXV provides a valuable tool for traders to identify the term structure of S&P 500 implied volatility and that a single value of the (SPX option) implied volatility is not enough.