In a previous blog post, “Where Is the Volatility?”, we broke down the construction of the VIX index. In it, we dispelled the notion that the VIX is a “fear index.” At its core, the VIX does not measure fear or volatility, but instead the supply and demand for short-term options. The supply and demand of various puts and calls are dynamic with their prices shifting according to market expectations.
In normal market conditions, volatility is expected to decrease when the underlying market rallies and increase when the underlying market falls, affecting the demand for calls and puts. Historically, downside movements have been much greater and faster than movements to the upside, some would say the markets take the stairs up but the elevator down. This rapid move to the downside causes people to buy more protection. Thus, there is a greater tendency to purchase downside protection when markets move down than the tendency to purchase upside calls when the market moves up. This difference between the demand for puts and calls creates what we call the volatility skew.
In January 2018, however, rather than taking the stairs up, the market took the elevator up. The upward move in the S&P 500 increased realized volatility and, as a result, also increased implied volatility, albeit at a slower pace than what a typical 6% trading range should justify. With the market at or near all-time highs, one would expect for volatility to be low, but the volatility curve was repricing itself and increased, instead of decreased, volatility, creating an interesting volatility skew.