We had a rather interesting situation yesterday.
The $SPY got hammered as sellers stepped in with gusto, and yet we saw very little movement in the $VIX.
What gives? If the $VIX is a fear index, why didn't we see more fear?
There were plenty of "reasons" doled out by the media. We heard about complacency, political reasons, investors were O.K. with the debt ceiling and so on.
But the answer is much more simple if you actually understand the market mechanics of the instrument.
Two Sides of a Coin
The $VIX is a statistic that measured the supply and demand for $SPX options premium.
If a bunch of premium buyers step in to protect themselves, the $VIX will rise as demand has risen, and if investors take a step back and don't buy options as a hedge, then the $VIX will fall as demand has dropped.
We can also consider the other side of the coin: if many investors are out selling options premium, the $VIX will drop as an increase in supply, and if there are no premium sellers to be found, the $VIX will rise to attract them back into their positions.
And that's why the $VIX behaves differntly than stocks. And why it mean reverts more often. And that's why it was divergent today.
Imagine a world where there are only 100 investors in the stock market, and a "magical" options market where you can only buy premium to protect yourself.
One day the market has a pretty nasty move lower, so 75 of those investors buy puts to protect their investments.
And then the next day, the market gets even uglier. What happens to premium demand? The 25 who are under-protected will probably want to add protection, but the 75 invesotrs already are hedged, so demand is not as strong.
That's when we see a divergence.
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