Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Why the VIX Volatility Smile Is Flattening Again
Transcript
- Lucas: The VIX closed at 16.78 yesterday, up about 3.6% over five days. Nothing dramatic on the surface — but the shape of the volatility curve underneath is telling a much more interesting story. Luna: You mean the volatility smile — the pattern where out-of-the-money puts and calls trade at higher implied vols than at the money strikes? Lucas: Exactly. And right now that smile is flattening in a way we haven't seen since mid-2023. The premium on out-of-the-money put options — the ones that pay off if the S&P 500 drops 10% or more — has been steadily declining. The skew is compressing. Luna: So investors are paying less to hedge against a crash? Lucas: That's the surface read, but I think it's more nuanced. Let me pull in the v vix — that's the volatility of volatility, or the VIX of the VIX. It closed at 88.43 yesterday, up a tiny 0.8% on the week. But 88.43 is historically low. For context, the long-term average is closer to 95, and during the 2020 crash it spiked above 200. Luna: Low v vix means the market expects the VIX itself to stay calm — no big swings in fear pricing. Lucas: Right. And that's consistent with a flattening smile. When the v vix is low, options dealers are less worried about being gamma-hedged, so they're willing to sell tail-risk protection at lower prices. The result: the put wing of the smile comes down. Out-of-the-money puts become cheaper relative to at the money. Luna: But the VIX itself is up this week — 16.78 versus maybe 16.20 last Friday. That's a 3.6% move. Doesn't that contradict the idea of complacency? Lucas: Good catch. The VIX level is modestly higher, but that's mostly driven by the at the money section. The real story is the shape. Think of it this way: the VIX is the level of the water; the smile is the slope of the beach. What we're seeing is the waterline coming up a bit, but the shallow end getting even shallower. The market is pricing in a higher near-term vol baseline — maybe because of the Fed uncertainty with the new Warsh chair — but it's simultaneously pricing out the probability of a severe tail event. Luna: So the market is saying: we might get more turbulence day-to-day, but not a crash. That's a pretty confident stance. Lucas: It is, especially with the macro backdrop we have. The Russell 2000 dropped 0.9% over the past five days. The yield curve has steepened — the 10-year minus 2-year spread is now 27 basis points, up from 22 a month ago. That's a classic signal that growth expectations are shifting. And yet the options market is charging less for crash protection than it did in December 2023, when the S&P 500 was at 4,700. Luna: What changed? Why is the smile flatter now than a few years ago? Lucas: I think there are two forces at work. First, the post-2020 normalization. After the pandemic crash, the smile was extremely steep for years — everyone remembered the shock and kept paying up for puts. That memory has faded. Second, the market has absorbed several scares — the 2023 regional banking crisis, the 2024 rate repricing — and each time the S&P 500 bounced back quickly. The options market is effectively extrapolating that pattern. Luna: Which is exactly the kind of extrapolation that can leave you exposed if the next shock looks different. Lucas: Precisely. And that's the tension here. The v vix at 88 says the market doesn't expect a vol of vol blow-up. The flattening smile says tail risk is cheap. But the macro data isn't pristine — real GDP growth is 1.6% annualized, which is below trend. The 10-year yield is at 4.49%, the highest in over a decade if you adjust for inflation expectations. And the Fed has a new chair in Kevin Warsh, who the market is still pricing in as more hawkish than his predecessors. Luna: So the options market is essentially saying: we've navigated this before. But 'this' might not be the same. Lucas: Exactly. Let me give a concrete example. In June 2023, right before the regional banking stress peaked, the VIX was around 14 and the v vix was in the low 90s. The smile was relatively flat. Then Silicon Valley Bank collapsed, and within days the VIX spiked to 26 and the v vix to 150. The smile steepened dramatically — put premiums surged. The market was caught off guard because the pricing had signaled tail risk was negligible. Luna: History doesn't repeat, but it rhymes. So what should a listener do with this information? Just be aware? Lucas: I think awareness is the main takeaway. If you're a long-term investor, a flattening smile isn't a signal to change your allocation. But if you use options for hedging, the cheapness of puts right now is actually an opportunity — not a reason to be complacent. Buying a bit of tail protection when it's on sale is the classic 'buy when others are not hedging' move. Luna: That's a good way to frame it. And it ties into something we've touched on in past episodes about the VIX collapse — the regime shift. But this flattening smile feels like a deeper layer of that story. Lucas: It is. The VIX level catches headlines, but the smile is where the real structure lives. And right now, the structure says the market is betting that the next five years look like the last five — that we've permanently exited the tail-risk regime of 2008 and 2020. That could be right, but it's a pretty aggressive assumption. Luna: And speaking of assumptions we make about the future — one thing that keeps this show going, ad-free and independent, is listener support. If these conversations have helped you think about risk differently, or if you just appreciate the deep dive into market structure, you can find us at buy me a coffee dot com slash fexingo. It's a small way to keep the podcast unfiltered. Lucas: Yeah, exactly. That kind of support really matters. It lets us keep digging into these niche topics without chasing clicks or sponsors. And speaking of structure, I want to circle back to one more data point that connects the smile flattening to real-world positioning. The VIX futures curve has also flattened — the contango has narrowed. The one-month futures contract is trading at 17.20, not much premium to spot. That means the market isn't even paying for time. Luna: So the entire volatility surface is compressing — spot, forward, and the smile. That's a coordinated signal. Lucas: Exactly. And when the whole surface compresses like this, it often precedes a volatility shock — not always, but often. In 2017, the VIX was in single digits, the smile was flat, and everyone said 'low vol forever.' Then February 2018 happened. Volmageddon. The VIX spiked from 10 to 50 in a day. Luna: Right, because of the short-volatility trade unwinding. But that was a different mechanism — more about positioning than macro. Lucas: True. The positioning today is less extreme in terms of levered short vol — the open interest in short-vol ETFs is a fraction of what it was in 2017. But the behavioral dynamic is similar: a consensus that volatility will stay low. And the danger is always that the consensus reprices faster than anyone expects. Luna: So the flattening smile is a canary, not a crash signal in itself. It's more of a yellow flag for awareness. Lucas: That's the right way to think about it. I'm not saying sell everything. I'm saying understand what the options market is pricing in — and don't assume it's the true probability. The market is often wrong about tails, which is exactly why tail hedges can be cheap. And right now, they are historically cheap.