Traders will often look at what is know as the "volatility risk premium" to determine if VIX is cheap or expensive. The volatility risk premium is essentially a comparison of the VIX (expected volatility over the next 30 days (annualized)) and HV20 (actual market volatility over the past 20 trading days, i.e. the trailing 30 days).
The logic is that the market going forward should typically experience a similar amount of volatility that the market has experienced in the past. However, we typically see a VIX greater than HV20 since sellers of options need to be paid a premium for a certain amount of risk that traders expect in the market. A greater amount of expected volatility will cause the premium to increase.
A simple interpretation of this measure is that VIX is considered "expensive" when it is much greater than HV20, and "cheap" when it is much less than HV20.
While this is a relative measurement, today's volatility risk premium of 90.6% looks pretty expensive. But don't expect to VIX to fall just yet.
First of all, the value is a ratio. As actual market volatility increases (during a large rally or large sell off) the ratio will get smaller (given a steady VIX).
Also, 90.6% isn't too crazy just yet. Below are some points over the past 10 years where the market saw other peaks in the volatility risk premium.
- 2/15/12 151.5% (VIX 21.14; HV20 8.40)
- 3/5/12: 153.6% (VIX 18.05; HV20 7.12)
- 5/18/12: 113.1% (VIX 25.10; HV20 11.78)
- 9/5/12: 195.2% (VIX 17.74; HV20 6.01)
- 12/28/12: 128.8% (VIX 22.72; HV20 9.93)
- 1/31/13: 157.8% (VIX 14.28; HV20 5.54)
- 4/1/13: 74.6% (VIX 13.58; HV20 7.78)
- 6/3/13: 62.9% (VIX 16.28; HV20 9.99)
- 8/9/13: 103.5% (VIX 13.41 HV20 6.59)
The highest this ratio got before the Aug 2011 selloff was 64.1%, which occurred on 8/1/11 (VIX 23.66; HV20 14.42). After that HV20 then pretty quickly rose to a lofty 50.66 (8/29/11) and the ratio hit -36.3%.
More fun facts:
- The highest HV20 over the past 10 years was 85.19 (on 11/5/2008).
- The highest VIX to HV20 ratio over the past 10 years was 289% on 12/31/10 (VIX 17.75; HV20 4.57)
Lastly, don't forget that if you trade VIX ETPs, they all track to VIX futures and what matters most is the term structure.
Happy Trading!
