We had a barrage of bearish headlines all week long and yet we closed just 2.2% from all time highs. The irony is that we are seeing near bearish extremes being printed across our data sets.
Our model now shows an volatility risk premium of about 6.3 volatility points. VIX closed at 17.15% while our model shows realized volatility should come in at 10.85%. The chart below (from our report) shows you this extreme disconnect.
We have the VIX printing a near 2 standard deviation move for the data that most closely fits the current market conditions.
There is a long right tail with realized volatility printing 35% far past the 99th percentile of our data set and 20 being about, the tail should never be ignored – however the probability is heavily skewed in favor of lower realized volatility.
To put this in context the mean volatility risk premium of the past 15 years has been about 3.3 volatility points. Our model is predicting nearly double that. We can also see that disconnect in this chart.
Our volatility cone shows implied volatility on all timeframes well above the 75th percentile. The VIX has historically tracked slightly above the 75th percentile line.
So what does this all mean? We are quite near to bearish extremes. We would absolutely not want to be short the market here as the probability of continued and extensive downside is minimal. We believe that the market is much more likely to rally in the short-term and that trades that seek to sell volatility, or benefit from upside directional moves are most prudent, with, of course proper risk management to protect you from the tails.