A Mind-Boggling Situation

The following chart is a bit mind-boggling. I have used Excel to draw it and since numbers do not lie, they require some thoughts to try making sense of the situation.

The blue line is the S&P500 index since 1980. The red line is the 21 days volatility processed by Excel and the yellow line is the VIX index. The light green light is the 1month standard deviation (Excel) of the S&P500.

We can observe that we have a close correlation between the red and yellow line (volatility) as it should be expected. You usually do have close correlation between volatility and standard deviation. However, the last few years, standard deviation has been increasing steadily while volatility has remained “relatively” subdued.

In my view, this “unusual” situation might lead to potential accidents. One example is the February 2018 “Volmaggedon” which wiped out the value of several “Short Vix” ETFs.  Will something similar occur again or are we witnessing a structural change in the market?

The following chart might be a hint to a possible answer.

VIX electronic trading is relatively recent and volume has increased tremendously. We can observe that the increase in Standard Deviation is somehow linked to the VIX volume trading increase.

On the other side, the S&P 500 trading volume has remained “regular” during the same period. The SKEW index (yellow line) can be a proxy for investor sentiment and volatility. The Skew Index measures perceived tail-risk in the S&P 500. It measures the relative expensiveness of options hedging. We had an average increase in the SKEW from 2009 to 2018. One explanation is that many financial institutions were, for regulatory purposes, obliged to hedge proprietary market risks. Why do we have a “collapse” in the SKEW index since last year? It is true that this “underlying” bullishness has translated into one of the most spectacular bull run recently.

Resuming this mind-boggling situation….

• We have an unusual increase in Standard Deviation (measuring the returns distribution of the S&P500).
• Extreme positioning in VIX futures
• “Regular” trading volume in the S&P 500
• Kind of unusual cheapness in option hedging (SKEW)

I truly welcome any comments and thoughts sharing.  The picture which pops in my mind is that the S&P 500 cash market (the patient?) is surrounded by a growing cloud of derivative experts (the doctors & specialists) who seem more concerned about the reactions and opinions of each other instead of the patient.  

Maybe the relative cheapness in option hedging (I am no option specialist) represents an opportunity.