As 20 percent of the ten most damaging stock market drops in history have occurred in the past month, investors who understand the need to hedge at the same time are benefited from having proper expectations for various scenarios. While various volatility measures such as the CBOE Volatility Index® (VIX® Index) negatively correlate to the stock market 70 to 80 percent of the time, with the VIX typically rising in value at a generally consistent ratio percentage, during periods of anticipated market volatility investors might expect different results.

Such could be behind the recent odd swings in correlation ratios, volatility experts tell ValueWalk. On August 21, 2015, when the stock market lost 3.19 percent of its value on the S&P 500, the VIX index, measuring “fear” in the market, was up 8.89 points. But Tuesday, as the stock market was down near 3 percent (2.96 percent), the VIX was only up 2.38 points. The returns disparity continued Wednesday, as the stock market rose 35 points, or 1.83 percent, as measured by the S&P 500, however the VIX dropped in value by 5.31 points. These are all moves that defy typical ratio percentage correlations, but those who actively trade the VIX or are involved in volatility index construction were not overly surprised.

What does the returns ratio disparity mean for the VIX, stocks and near term volatility? As investors look to hedge a potential historic Fed interest rate hike, risk management certain funds engaged in this past July, having proper expectations a VIX hedge could be a key component of delivering proper noncorrelated performance during crisis.

Credit Suisse notes put pricing inversion in S&P 500 delivery months

According to Credit Suisse Group AG derivatives analyst Edward Tom, out with a research piece Wednesday, investors should anticipate that if the stock market falls hard in the near future the VIX may “muted” in that it night not appreciate to the same degree it did on August 21. He points to an inversion in the pricing on S&P options between the September and October delivery months and says that with this in place, VIX investors should anticipate such a “muted” price reaction. He wrote:

For Tuesday’s calculation, VIX was interpolated using the Sept 25th weekly with 24 days to expiry and the Oct 2nd weekly with 31 days to expiry. Today, however, the Sept 25th contracts will be eliminated as in input to the VIX calculation and full weighting will be place on the lower volatility Oct 2nd expiry. (editorial note: VIX experts offer the correction that it is a "good portion" of weighting, not full weighting.)  If S&P term structure remains inverted, in the following trading sessions we would expect to see a muted response of VIX (i.e., an underperformance of VIX to skew) to market pullbacks as an increasing portion of the spot VIX calculation biases towards lower volatility S&P options contracts.

Term inversions are causation for “muted” VIX pricing

In a volatility alert titled “VIX Levels Suppressed by Term Structure Inversion,” Tom says the odd relative value pricing, particularly the VIX under-reacting to S&P 500 stock price declines, is “a by-product of the steeply inverted S&P term structure.”

Normal term inversions have “a positive gradient,” Tom wrote, noting that the further out options months are more expensive than the options priced near expiration. Such a normalized term structure “imparts a positive drift to VIX levels over the course of the week as the contract weighting shifts towards the back month contract,” he wrote.

Inversions on the yield curve, in commodities and with the VIX, all have meaning

“Term inversions” occur when the front month of a contract is trading at a higher level than the back month. While Tom measured a term inversion using SPX put options, which is part of the underlying formula that drives VIX pricing, the relationship among front and back options month are less visibly inverted. The VIX index and the futures are not always correlated to the degree one might expect. At times VIX futures will invert while the cash has not, and at times the prices do not move in exact unison.  It is the VIX futures contracts where traders typically focus, as expectations for future volatility can be clearly seen. The September VIX future, for instance, closed Wednesday at 28.30 while the October VIX future closed at 23.87, a relatively rare price inversion has been in place for nearly a week.

What a term inversion means for the VIX

In the VIX index, a term inversion often signals market participants are anticipating future or sustained volatility.  In commodity derivatives term inversions occur when a particular commodity is in short supply but that supply may be more readily available in the distant future, thus reflecting a value adjustment across the time horizon of a derivative.  Along the yield curve, when an inversion occurs it is often the precursor of negative economic conditions to come. Under rare circumstances when long term interest rates yield less than short term interest rates this typically is a sign of an expected recession.

Differing relative values of VIX moves depend on the market “surprise”

Those that develop and manage volatility indexes see slightly different causations and draw slightly differently conclusions. Author and director at the Options Institute at Chicago Board Options Exchange Russel Rhoads, along with Scott Nations, who is working with the International Securities Exchange SE is working to launch an options volatility product based on the Nations VolDex index (ticker: VOLI). The further the VIX price strays from its normalized average, like a magnet, the less relative strong price movement should be expected to impact the VIX.

“The VIX is its own animal,” Rhoads said, noting the correlation between the S&P and VIX is near negative -0.80. As such, it has its own mean reversion characteristics.

“The market was surprised August 21 and this shock is reflected in the price movement of the VIX (which was up 8.89 points on a 3 percent move in the S&P),” Rhoads said in an interview with ValueWalk. “The market was less surprised September 1 (when the VIX was up 2.38 points on a relatively similar move down in stocks). There was less fear. The VIX was reflecting the notion that investors are now anticipating future volatility.” In this anticipatory environment, investors should expect less surprise at a different relative move in the VIX.

Nations noted that surprise factor as well as causation for a strong August 21 but muted September 1 showing for the VIX. He says the out of the money puts used in the VIX formula can provide a degree of volatility to VIX pricing. As the stock market moves drops, and those low cost and lightly traded out of the money options come closer to being in the money, that volatility in the measure of volatility is to be expected.

There is also an anticipated trading range in which the VIX operates. When trading exceeds that range the index is known to exhibit mean reversion at some point. For instance, Rhoads, who teaches courses at the CBOE, notes that in 2009, with the VIX traded near a mean average of 25 for a significant period during the year. When the index traded significantly below the mean the relative impact of the move was lessoned. During much of 2014, the mean had changed to the point where 15 was closer to the mean. Initial moves away from 15 can be expected to have a degree of magnitude, significantly moving the VIX index. Subsequent moves might not be as powerful. Wednesday’s large move down in the VIX – over 5 points on a 35 point up move in stocks – would have been a much more minor price move if the VIX wasn’t trading at the upper range of its range and volatility was not as acute.

On a fundamental level both Nations and Rhoads said the August 21 stock market move caught investors by surprise. Rhoads says sophisticated hedgers were concerned about economic numbers and look ahead to the Fed tightening with trepidation. In other words, a ripe market environment for volatility to strike.

Is the Fed overly “data dependent” on the S&P 500 price volatility?

While Rhoads, like many market analysts, cites Fed watching as being in the center of volatility, could this be a virtuous circle? Is the Fed itself watching stock market volatility and using this as a guidepost? So thinks Pension Partners Director of Research Charlie Biello.

Writing in a blog post Wednesday, Biello, after saying the economic “data” does not warrant zero interest rates, said the Fed might be too influenced by stock prices when making decisions:

The Federal Funds rate was moved to 0% in December 2008 during the worst recession since the Great Depression. The U.S. economy entered an expansion in June 2009 and while it certainly has been below average in terms of the growth rate, we’ve come a long way since that point in time.

If we focus only on the economic data, there’s almost no justification for the Fed Funds rate to remain at 0%, the same level where it stood in the depths of the financial crisis when the Unemployment Rate stood at 10%. We can argue over whether it should be 1%, 2% or higher, but 0% does not seem rational given the “data.”

Noting that the tail now appears to be firmly wagging the dog, Biello observes the Fed is watching the stock market to take their signal on raising rates, as evidenced by New York Fed President William Dudley saying a September hike was “less compelling” given “financial-market developments.” He draws an interesting conclusion:

It is the stock market tail that has been wagging the Fed dog in recent years. In 2010 and 2011 when the Fed was expected to begin “normalizing” interest rates, sharp stock market declines (17% and 21%) and spikes in volatility (above 40) derailed those plans and new rounds of easing (QE1/Twist/QE2) were initiated instead.

So to conclude with head spinning, the Fed rate hike could be creating uncertainty that is in the middle of stock market volatility.  The Fed decision making the rate hike, however, is impacted by the very stock market volatility under which the Fed is apparently influenced.

Will there ever be a good time to raise interest rates? And with a known issue of Fed tightening potentially driving volatility, are sophisticated investors aware of the more cost effective hedging techniques generally not disclosed in textbooks?