Why Is the VIX So Low?

When stocks fall, there are plenty of experts explaining why that happened, but you rarely hear such explanations when the VIX falls. This is because the VIX tends to go down when the market is calm and there is no “market moving news” to explain the (in)action.

The market is calm, because there is no reason for it to be worried and volatile.

The VIX is low because there is no reason for it to be high.

If that is not a sufficient answer to your question, let’s take a closer look. Why does the VIX fall and why is it currently so low?

We must first understand what exactly the VIX measures:

The VIX measures expected volatility of the S&P500 index over the next 30 days.

Low VIX = Low Expected Volatility

What is expected volatility? Expected by whom?

Expected by the market, or more precisely, by the traders buying and selling options on the S&P500 stock index.

Options are generally more expensive when expected volatility (in the period from now until the option’s expiration) of the option’s underlying asset (in this case the S&P500 index) is high.

The VIX is calculated from the prices of a wide range of options on the S&P500 index. Very simply, though a bit inaccurately said, the VIX measures implied volatility of S&P500 options which expire 30 days from now.

You don’t need to understand the details of VIX calculation to be able to understand how and why the VIX moves, but if you are interested, here I have explained VIX calculation in detail.

What you need to know is that the VIX measures how volatile option traders think the S&P500 index will be during the period from now to 30 days from now.

For instance, if the VIX is 19.20 right now (approximately the long-term average value of the VIX since 1990, when its available history starts), it means the market expects volatility of the S&P500 index over the next 30 days to be 19.20%.

Low Volatility = Smaller Moves

What does a 19.20% volatility mean?

Simply said, volatility is how much a price or index moves. Higher volatility means price changes a lot from day to day, or week to week, or month to month (think a stock going +2.8% one day, -3.5% the next day and so on). Lower volatility means price is more stable and its daily or weekly changes are smaller (like +0.5% up or -0.3% down).

Volatility does not measure direction. It does not matter whether a price moves up or down, only how big the move is, to either direction.

More precisely, volatility, as it is usually understood in finance, is the annualized standard deviation of daily logarithmic returns of an asset.

The above sentence contains full recipe to calculate volatility from daily stock prices or index values (steps: 1. Calculate log returns 2. Calculate their standard deviation 3. Annualize). Again, most people don’t need to know the exact calculation (ambitious option traders should, and it’s not that hard, once you try a few examples on your own, for instance in Excel).

For now, it is enough to understand that there is direct relationship between volatility and general size of daily moves, and there is a simple way to convert the volatility number (or the VIX index value) to more useful information about daily stock price moves (or S&P500 index moves).

Converting VIX to Daily Volatility

Because volatility expressed by the VIX index is annualized standard deviation and you are usually more interested in daily S&P500 changes, you first need to convert the annual volatility to daily. You can use the rule of 16 and simply divide annualized volatility (the VIX value) by 16 to get daily volatility.

Why 16? Because 16 is the square root of 256 and there are approximately 256 trading days per year (more like 252 trading days, but square root of that is not a round number, and 256 is close enough for rough quick calculation even in your head; feel free to use square root of 252 = 15.875 when using Excel or a calculator).

Why square root? Because volatility is proportional to the square root of time, not time itself (see why).

Applying the rule of 16, when the VIX index is 12.00 for instance, it translates to expected S&P500 daily standard deviation of 12/16 = 0.75%.

Distribution of Daily Moves

The above said, a VIX value of 12 and daily standard deviation of 0.75% does not mean the S&P500 will go up or down 0.75% every day in the next 30 days. Some days it will move more, and other days it will move less.

More precisely, with VIX at 12 we can expect daily S&P500 changes to be:

  • Between -0.75% and +0.75% (one standard deviation) on 68% of days = about 2 in every 3 days.
  • Between -1.50% and +1.50% (two stdevs) on 95% of days = 19 in every 20 days. In other words, the S&P500 is expected to drop more than -1.50% or advance more than +1.50% in a single day approximately once in every 20 trading days, or about one trading day per month.
  • Between -2.25% and +2.25% (three stdevs) on 99.7% days = below -2.25% or above +2.25% once in every 300-400 days = less than one trading day per year (but not never!).

One more example: If the VIX is 32, expected S&P500 daily standard deviation is 32/16 = 2% and expected S&P500 moves over the next 30 days are the following:

  • Between -2% and +2% (one stdev) on 68% of days.
  • Between -4% and +4% (two stdevs) on 95% of days.
  • Between -6% and +6% (three stdevs) on 99.7% days.

Two notes:

1) The VIX index value and the above numbers derived from it are what the market expects. Reality can be very different. See Difference between Implied, Realized and Historical Volatility.

2) The percentages (the “68-95-99.7 rule”, useful to remember) are properties of normal distribution. Common uses of volatility, like most other financial theory, assume price and index changes (returns) to be normally distributed.

In reality, distributions of most assets’ returns are not exactly normal, but close enough for most purposes. Most assets tend to make extremely big moves slightly more often than suggested by normal distribution, and extremely large down moves tend to be more frequent than up moves of similar size (in other words, markets rarely “crash up”). These characteristics can be measured by the statistics of skewness and kurtosis, which are beyond the scope of our current discussion.

So Why Is the VIX Low?

We now understand that the VIX index, calculated from S&P500 option prices, measures how big or small moves traders expect in the S&P500 index in the next 30 days. We have learned to interpret the VIX value as daily S&P500 move sizes and their expected frequencies.

The VIX falls when traders expect the S&P500 to generally move less in the next 30 days. Lower expected volatility makes options generally less attractive. Option sellers become more aggressive (more eager to sell, even at lower option prices) than buyers. This makes S&P500 option prices, as well as the VIX index derived from them, go down.

While you can never identify a single reason that makes traders adjust their volatility expectations downwards (and each trader thinks differently), there are a few common factors that tend to contribute to lower volatility expectations and lower VIX.

Common Factors Contributing to Lower VIX

Seasonality and holidays. Market activity tends to calm down around holidays. Trading volume declines, and so does volatility. This may seem counterintuitive, as lower liquidity makes the market prone to sharp price moves if there is some unexpected event or news. However, such big market moving events are also much less likely to occur during or around holidays. For instance, companies rarely issue warnings of lower profits or other important announcements the day after Christmas, as most of the management are at home. This is why we often see the VIX making major lows in December, November (Thanksgiving), or July (July 4 holiday and the summer holiday season) – see overview of days with all-time lowest VIX.

Positive news, or some widely feared event no longer feared. For instance, the VIX may be elevated before an election, if the market fears that a business-unfriendly party or politician may win. If the actual result turns out more positive for the market, the VIX sharply falls after it is announced. As another example, if the market is worried the Fed will raise interest rates and it does not (or a Board member interview suggests it may not), the VIX will go down. You can think of options as insurance against market losses, option prices as the price of that insurance, and a decline in VIX as a decline in demand for that insurance.

Another common reason for low VIX is complacency, or simple passage of time when nothing big happens in the market. Using the insurance analogy again, if the negative thing that you want to insure against does not happen for a long time, you may start to feel the insurance is not that urgently needed, and you may be less willing to pay elevated premium for that insurance. When the market is all good and only going up for a long time, many investors start to feel nothing bad can happen any time soon. Lower demand for options (insurance) = low VIX.

Extremely low VIX readings often arise from a combination of multiple factors which fall into one or more of the above categories.