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State of the Volatility Address


Higher stock correlation, higher volatility.

So why is the VIX just not doing what it's "supposed" to do these days? By that, I mean of course, why does it sit in the 40s in what seems like a 70-VIX world we trade in - at least if you trade in anything financial?

Quite simply, it's just not a 70-VIX world.

The VIX is a statistic used to estimate the volatility of a 30-day option on the SPX. It's the estimation of the marketplace for actual stock volatility over the next 30 calender days. The market is not a perfect seer. Options volatility, in fact, correlates better to realized stock volatility of the recent past then it does to actual volatility in the immediate future.

The following chart shows 10-Day Historical Volatility of the SPY. It's a noisy number, prone to one cosmic day throwing it out of whack. But that also means that one cosmic day will leave the calculation in 2 weeks. Basically, it's a good barometer of the volatility the market itself feels in the here and now.

Each horizontal line corresponds to the start of a calender month. And as you can see, actual market volatility by this measure has fluctuated between 20 and the low 40s for the entirety of 2009.

The next chart shows 30-day normalized volatility on the SPY (yellow line) and 30-Day HV (blue line). The yellow line will pretty much equate to the VIX, although generally with lower absolute numbers, as the VIX incorporates many pricey OTM puts into its number, whereas the proprietary formula used by ivolatility appears to assign them a lower weight.

And as you can see, 30-day implied volatility pretty much equals 10-Day HV. It may seem more volatile than that, but numbers are numbers.

Finally, up top, we have 2 gauges: Average True Range and BBWidth. Both blew the doors off in the autumn swoon, but now, only BBwidth shows signs of spiking.

So what's going on?

Remember, index volatility has 2 components to it: volatility of the individual stocks in the index, and the degree to which they correlate. Higher correlation leads to higher volatility.

Don Fishback
runs numbers on all this, and indexes volatility of the component stocks. We exchanged some emails the other day, and according to Don, individual stock volatility as a whole is running very high, albeit not quite at levels seen this fall. So it's the correlation, or relative lack thereof, that's causing index volatility to lag somewhat.

So if there's one thing to look for here, it's that correlation. Perhaps days like Friday - where we saw tech get slammed along with the banks.
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