DailyFX.com -

Talking Points

• The FX Volatility Index is near its highest level in four years

• A speculative element has altered the simple ‘haven’ appeal these measures are attributed

• The strong speculative short view in VIX futures and sharp rise in open interest highlight distortion

See the DailyFX Analysts' 2Q forecast for US Oil along with their favorite 2016 trading opportunities on the DailyFX Trading Guides page.

Volatility measures for many of the key asset classes have withdrawn to remarkably low levels. However, the backdrop for market risk and the persistence of FX volatility signal conditions are far more troubling than what these simple indicators may suggest.

Most implied volatility measures are backed out of their relative, underlying products’ options pricing. This is essentially the cost of the unknown. And, if these products are used to hedge their underlying exposure from adverse moves, we end up with an assumption of market direction. Since the bulk of market participants in equities for example are of the buy-and-hold mentality, the hedge is usually against declines which makes the stock-oriented VIX indicator a favored ‘fear’ gauge. However, these simplistic interpretations do not always hold.

Below is the net speculative positioning among large trader in the futures product based on the VIX Index. As can be seen, there has been a sharp increase in short positions for VIX futures despite the underlying index standing at the lower bound of its range the past year. That may reflect an optimism for ‘risk appetite’ that see equities and the like advance, but why build a significant short in an already thin return derivative? With derivatives, there is a time value that can be collected by the short side but is worth very little in the way of return. It is a topping off return but draws considerably more risk than yield. The saying is ‘picking up pennies in front of a steamroller’.

Another interesting circumstance is the level of exposure to this popular volatility product. Volume or trading in the VIX futures tends to follow the level of the market – higher volatility generally begets more reaction – but open interest is more sentiment oriented. Open interest is the total exposure the market has to this product, and we have seen a remarkable swell over the past few months back towards record highs of past years. This could be a speculative reach, but it is more likely the reflection of a market increasingly uncertain of its risky exposure and a demand for insurance.

While the VIX index for equities is perhaps the most popular measure, there are measures for many asset classes including bonds, emerging markets, commodities and FX. Similar to that for equities, volatility measures for commodities like gold and oil, Treasuries and emerging markets have substantially deflated from their early February swells. As with shares, this may reflect a blend of speculative reach and a warped haven appeal. Yet, what we can also garner from this comparison is that FX volatility seems to be holding more persistently buoyant.