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One fun thing about the VIX — called the “fear gauge” because it puts a price on expectations for future stock-market volatility — is that it has pretty deep lore.
For example, the army of young daytraders who first logged on in 2020 might not know much about 2018’s Volmageddon, when an implosion in retail-focused volatility products and swings in the S&P 500 options that determine VIX levels helped exacerbate declines in the large-cap index itself. It also may not be obvious that it’s a mathematically iffy business to talk about its moves in percentages, because it’s basically a standard deviation, or a percentage itself.
The BIS adds to the canon in a recent bulletin: the past summer’s massive VIX move can be explained away by a quirk in the way the index is calculated during the trading day.
Remember August 5? If you were on leave (or vacation) then, there was a global sell-off in equities. The worst of the stock-market losses happened in Japan, and were presumed to be a result of a rapid unwinding of the yen “carry trade”. In response, the VIX spiked above 65 early in the trading day. If it had stayed there, it would’ve closed at its highest level since Covid or the global financial crisis.
But a carry-trade unwind isn’t exactly a global pandemic or a subprime mortgage meltdown. The VIX captures what traders will pay to protect against volatility in the S&P 500 over the next month, by weighting a range of options on the index. Presumably US large-cap companies hadn’t piled significant portions of cash into yen carry trades, so what gives?
The VIX spiked because its minute-to-minute moves are calculated based on quoted options pricesnot transactions, according to the BIS. (Kudos to Peter Tchir, who as we noted raised this possibility in the wake of the spike.)
In other words, options market makers got spooked because they saw some extreme moves in overnight trading. And because they didn’t want to get run over once the market opened, so they made it very expensive to buy protection against volatility.
In BIS’s more demure parlance, with our emphasis:
[The] asymmetric widening of bid-ask spreads likely played a key role in exacerbating the spike, as it lifted mid-quotes of option prices used in the calculation of VIX . . .
Market makers’ (MMs) adjustment of quotes was behind the widening, as MMs sought to avert an imbalanced book in uncertain conditions. These effects were particularly strong for less liquid put options, which have an outsize impact on the calculation of VIX and accounted for more than 85% of the spike.
That means it really did represent pure fear — and primarily from market makers — without the actual trades to back it up.
There’s not much we love more than a messy benchmark here at Alphaville. For the VIX, however, it kind of makes sense to use quotes and not transactions, partly because the index includes deep out-of-the-money options that rarely trade.
And that’s all the more reason to take any intraday VIX move with a giant pillar of salt. BIS:
Our findings highlight the possibility that the calculation of VIX makes it vulnerable to a widening of bid-ask spread quotes regardless of a fundamental rise in underlying volatility. The outsize role of less liquid put options in the calculation of VIX exacerbates these problems. Given the subdued liquidity in overnight option markets and reliance on quotes instead of trades in the VIX methodology, pre-market readings of VIX may be less informative than those during regular trading hours.
Find the paper here for the their latest entry into the Book of Vol.