On Wednesday in the Deutsche Bank research report, Strategy Dashboard – VIX Under 11? Play Carry Trades Safely, Keep Watching Rates, it?discusses volatility and option strategy pricing while noting that as the?VIX hit a new, sub-11 low last Friday, market players shouldn’t become too complacent.

Here’s a few notes from the report:

  • Friday?s 10.73 VIX level was the first sub-11 print since 23-Feb-2007. Falling VIX and ATM IV levels have been driven by sliding down the SPX skew. However, on a fixed-strike basis upside vol has been stable to rising which slows the decrease in ATM IV levels.
  • The ~4M of generally sub-11 VIX levels that ended in Feb-07 ended dramatically. Two days after what became the last sub-11 VIX level for 7Y, the SPX dropped 3.5% – its only 7-sigma (vs 3M RV) one-day move since 1990 (and 12th since 1928) ? a true tail event. Small moves from a low IV level can be especially dangerous to short vol/vol-of-vol positions.
  • Low VIX levels have driven large UVXY inflows. The combination of large 2x/-1x VIX ETPs and low IV implies that if the futures curve jumps a 2007-like 3 vol points, ETP issuers would have $35mm vega to buy.
  • The SPX IV curve has become increasingly concave: steep front, flat back after short-dated and long-dated IVs have fallen more YTD than ~6M. The shortest maturities are particularly cheap. For very cheap protection through the Fed meeting and press conference, we suggest: buy SPX 20-Jun 1910 (98%) puts for $1.90 (indic. ask, ref. fut 1949) ? 0.1% of spot.
  • While most asset classes are showing new lows in IV and RV, we are keeping a close eye on rates after a nearly 25bp 10Y move in the last 2W.
  • RTY IV is well off its lows ? but this seemingly rich Russell-SPX vol spread was normal pre-2007 as M&A activity kept small cap stocks moving.

Short vol can work as Deutsche Bank recommends using options given cheap vol-of-vol. Here’s a few additional thoughts.?

  • IV could potentially drop further ? but each step lower becomes harder. IV looks rich vs. SPX 3W RV of 7% , but not vs. 11% year-to-date SPX RV.
  • Overall, the IV moves probability distribution is weighted toward the upside ? sharp upside moves possible but sharp downside moves increasingly unlikely. We recommend structuring short vol strategies using options to avoid large drawdowns. Vol-of-vol helps: VIX and VXX IVs are fairly low ? and good value given historically aggressive roll-down.
  • Even absent further IV declines, the VXX can continue to drop quickly: the steep VIX futures curve and two consecutive short, 19 trading day, roll periods sets up the VXX to lose almost 50bp/day, or around 9% per month. 20-Jun 29-strike puts for $0.30 (indic ask, ref. 30.20) correspond to around a 13.35 strike put on the average VIX future for $0.13.