Traders work on the floor of the New York Stock Exchange (NYSE) in New York on Feb. 29.Michael Nagle/Bloomberg
Amid a period of unusual market calm, traders in the U.S. are preparing for a typhoon from across the Atlantic. The one-month realized volatility of the S&P 500 Index stands at just 6.5 per cent, its lowest level since 2014, while the CBOE Volatility Index (commonly known as the VIX) closed near 21.2 on Wednesday. Yet, "implied volatility is extremely high when you consider how little the market has actually been moving," writes Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors.
The VIX Index is a measure of the implied volatility of the S&P 500 over the next month, derived from at-the-money options prices. "Looking back 10 years, we find this is actually the highest the VIX has ever been compared to S&P 1-month realized, in a low realized environment," he wrote in a research note today. "In other words, the spread has been higher, but that's because S&P realized was already high, perhaps due to a big market move (e.g. Aug 24) and the vol market was pricing in further volatility."
A loose definition of a 'low realized' environment is a reading under 20, he said.
Other recent cases in which the ratio between low-realized volatility and implied volatility became elevated include a quiet holiday trading season in 2010 where realized volatility plumbed post-crisis lows, and the month after the flash crash in Treasuries in 2014. The current level of the VIX will not certainly persist for long, and is poised for a huge swing depending on the outcome of the U.K. referendum, Chintawongvanich argues.
"The VIX at 21 is pricing in a binary outcome: either it collapses back to 14-16 on a 'Bremain' vote, which would be a more appropriate level for the extremely low realized, or it soars higher on a 'Leave' vote," he writes. Assuming financial markets are roughly in line with betting markets, VIX at 15 would be the 'Bremain' level, he said, while 'Brexit' VIX would be 37.1. "That doesn't seem unreasonable considering VIX spot got to 40+ in August 2015."