Look at relative Volatility between FXI and SPY

With the US Stock markets down more than 2% today following a sell off in Asia, the spot VIX has spiked more than 23% to 27.5 as of 2pm EST. As I have noted in my previous post, and also by other fellow options bloggers, the VIX is trading at a large premium over the realized volatility of the SPX itself and therefore it seems that rather than the market being very complacent, fear could actually be overpriced. If we close at the current levels today, the 1m realized volatility will still only be at 16%, making that premium even higher than last week at over 11. So in this market is there a better way to hedge the downside should it materialize?

To answer that, I looked to what the pundits are considering the culprit of today's action, the Chinese stock market, and whether the options there are offering better hedging opportunities than the S&P 500 options. As a proxy, I am looking at the U.S. traded ETF, the iShares FTSE/Xinhua China 25 Index (FXI). In the chart below, I have plotted the 3mth realized volatility of the FXI relative to the SPY (blue line). The lowest recent reading is just a bit shy of 1.5 earlier this year, meaning the FXI was 1.5x as volatile as the SPY on a 3mth basis. Prior to that, one would have to go all the way back to 2005, to find a reading below 1.5 (the absolute low was 1.26 in 7/2005), so it seems that 1.5 is a good rule of thumb for the lower bound of this relationship.




Looking at the November options for the FXI, with approx 3mths to expiry, the ATM volatility is quoted at about the 42% level. While there is no November options for the SPY on the board yet, the volatility term structure between the Oct and Dec ATM lines is quite flat at about 25.5%, which we will interpret as the Nov implied vol. The ratio between the two at 1.65 (Red line in graph), is the current market's expectation of the relative volatility between the two markets, and compared to the historical figures, is actually very much towards the low end. The current reading is in the 16% percentile of all historical readings, meaning there has been a 84% probability of the actual realized ratio being higher at expiration.

Although it may well be true that the turn in the Chinese market is foretelling a correction in the US one, the timing might not be coincident. It might also be that the Chinese market is more overvalued, having rallied 100% off the lows, compared to only 50% for the S&P 500. Regardless, by looking at the historical ratio of the realized volatility between the two, it appears that risk premium in the FXI is priced relatively cheap compared with the SPY, and a ratio adjusted trade might therefore offer a better risk reward alternative to purchasing outright protection in the US markets.