Regarding That Inevitable VIX Pop
It pays not to assume volatility will soar here.
It's pretty conventional wisdom right now that the VIX is headed higher. VIX futures have held their premiums to the "cash," and meanwhile, there's an awful lot of speculation in cheapie VIX paper.
Bernie Schaeffer looks at the other side of that trade.
So why don't I just get with the program and issue a stern warning to you that volatility is headed higher, and, by implication, stock prices are headed lower? For one thing, while no one doubts the sophistication of these options professionals, note that they began favoring VIX calls in 2008 well before the VIX took off -- in other words, they were pretty early. In addition, they are just as vulnerable to getting caught up in 'group think' as the rest of us, and the confident pronouncements from almost all quarters about the inevitability of a volatility surge strike me as a consensus that one should consider fading. Lots of money has already been laid down on this higher volatility play, which means that there could be some itchy trigger fingers if the trade does not develop as expected, which would in itself put downward pressure on volatility. Note that volatility no longer "just happens" as the result of the meanderings of stock prices -- it is also a tradable asset and the 'price' for expected volatility is determined by supply and demand. And if the trading community leans heavily to the buy side on volatility, an unwinding of this trade would cause volatility expectations to plunge. And, without getting deeply into the details, declines in volatility expectations can also dampen realized volatility.
Whether this scenario plays out or not, he's of course spot-on with the dynamic. The desks and all are likely pretty long volatility these days. That, in and of itself, can dampen realized volatility as on the margins, you now have more supply and demand on both sides of the market.
Well, active traders and trading desks are the most likely players out there to hedge their delta exposure. So the thinking goes that if they're long gamma, they're in the stocks hedging on a relatively aggressive basis.
And of course, if realized volatility stays muted, it will ultimately reduce options volatility.
As Dr. Schaeffer also points out (and has been noted here often this past month), the VIX, if anything, is modestly high compared to both realized volatility and individual stock volatility. So it really pays to not just assume volatility will soar here. It might -- but there's an equally good argument why it might not.
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