Cboe rebuts Sammers' doubts: "VIX, the 'fear index', surging during market panic is not surprising"

The Chicago Board Options Exchange (Cboe), the largest options exchange in the United States, refuted the doubts raised by former U.S. Treasury Secretary Summers, stating that the sharp rise in the Volatility Index (VIX), also known as the "fear index," last Monday was not unexpected.

Cboe acknowledged that the thin pre-market trading had a certain impact on the drastic fluctuations of the VIX, but stated that the surge in VIX was reasonable because it confirmed investors' increasing concerns about the contagion risk triggered by the yen and stock market collapse. It was this concern that led to the unwinding of yen carry trades.

On "Black Monday," August 5th, global stock markets experienced a significant downturn, and Cboe's VIX volatility index surged by 181% to 65.73 at the beginning of the U.S. stock market trading session. An article on Wall Street News mentioned that the VIX reached its fourth-highest level in history, only surpassed by the financial crises of 1998, 2008, and the outbreak of the pandemic in 2020.

Mandy Xu, the Director of Derivatives Market Intelligence at Cboe, stated that when the VIX surged last Monday, the S&P 500 futures dropped by 4.5%, equivalent to an annualized volatility of 70.

"Considering the significant pre-market fluctuations in S&P futures, it is not surprising that the VIX index experienced such a significant shock."

Some experts measuring volatility mentioned last Monday that the drastic fluctuations in the VIX index may have been caused by several technical factors, including a significant lack of liquidity, short covering from failed volatility bets, or simply the calculation method for measuring volatility. They believe that the surge in VIX last Monday may have exaggerated the bearish sentiment, as the abnormal price difference between VIX and its futures contracts indicates a disconnect between the fear index and market reality.

Former U.S. Treasury Secretary Summers stated on a TV show last Friday:

"My understanding is that the volatility of the VIX index on Monday was somewhat artificial due to the use of illiquid instruments in calculating the VIX index."

While the VIX surged to 65.73 last Monday, the August VIX futures linked to it only rose by about 5 points. The gap between VIX and the front-month contract widened to a record 32 points. However, this gap did not last, narrowing to 8 points by the end of Monday. Some market observers believe that the rapid narrowing of the gap between VIX and its futures indicates that the initial rise in the VIX index may have exaggerated investors' panic.

The fact reflected by the above views is that the VIX itself is not actually traded by investors; it is a mathematical quantity derived from the prices of S&P 500 index options. In contrast, VIX futures contracts reflect actual fund flows.

Cboe expert Mandy Xu pointed out that the discrepancy between VIX and its futures this time highlights a completely different background compared to the period during the COVID-19 pandemic. During the pandemic, VIX and its futures soared year-over-year. Xu stated in the report,

"The pandemic was both a liquidity event and a macro shock, while what happened this Monday was purely a liquidity event. This trend has no fundamental/macro reasons, so there is no reason to expect that volatility will remain high after deleveraging." Founder of derivative analysis company Asym 500, Rocky Fishman, believes that a volatility-based trading strategy called Dispersion Trading may have driven the rise in VIX. Wall Street News introduced this options strategy back in May, which involves selling Nasdaq 100 index options and buying individual component stock options such as Nvidia or Tesla.

Investors using the Dispersion Trading strategy typically bet on low index volatility while betting on higher volatility of its component stocks. However, last Monday, VIX surged pre-market along with the rise in S&P 500 options costs, surpassing the costs of Apple and Microsoft options, breaking the conventional pattern of these two S&P component stocks having higher costs. Fishman believes that investors using the Dispersion Trading strategy have fueled the volatility of VIX.

Cboe's Xu disagrees. The expected correlation between S&P 500 index component stocks has slightly increased. According to her model, the one-year implied correlation increased by only 4 percentage points last Monday, reaching 28%, well below the five-year average of 38%. She wrote in her report, "Last week's movement was not driven by the unwinding of Dispersion Trading."