In response to my earlier post on why options markets are being overly sensitive, Eli Mintz offered an interesting alternative explanation of the data:
@condoroptions My interpretation is more benign. I think that the market is just pricing lower average volatility long term.
— Eli Mintz (@VixCentral) April 30, 2013
Here’s why this is a plausible explanation of those recent flattening periods in the VX slope. If the market is expecting lower volatility over the long term, that should make VIX futures prices at longer horizons more “sticky” during short term volatility spikes. So if SPX declines 3% or so but lower long-term vol expectations are in place, we would see some movement at the front end of the VIX curve but not as much on the back end, and that would entail some flattening in the term structure even if the short-term vol reaction wasn’t extreme.
That’s a persuasive idea and it would make sense if it were true. How much weight should we give the notion of lower vol expectations? This chart shows the daily changes in VX June futures over the last few years – excluding April, May, and June since the futures become much more volatile closer to expiration. Over the last few months, the June 2013 contract has been acting normally: less volatile perhaps than the June 2012 contract was, but the same or more volatile than the 2010 and 2011 contracts. The mean value of the most recent series is lower than in previous years, which is also consistent with the idea of a gradually lower price for medium term volatility.
At the same time, there’s still something to the idea that markets have been more reactive lately in the short part of the curve. Look at the ten day standard deviation of the daily VIX close:
The most recent spike was the highest we’ve seen since the August 2011 European debt crisis. And you can clearly see the three spikes in this series corresponding to the flattening term structure that inspired my earlier post. Another way to characterize this is that the realized volatility of implied volatility is higher than it has been in some time.