Analyzing the Relationship of Equity and Volatility
Indexes are highly correlated but diverge every day.
It's very uncommon for both the equity indexes to all close higher and for their implied volatility indexes to all close higher on the same day. To clarify, the condition we're looking for is one in which all of the S&P 500, the Dow Jones Industrial Average (DJIA), the Russell 2000 (RUT), the NASDAQ 100 (NDX), and their respective implied volatility indexes (VIX, VXD, RVX, VXN) close higher than the day before.
Since 2004 -- the first date for which RVX data are available -- that's only happened 19 times; the most recent instance was last Monday, July 27. Intuitively, such an occurrence might be a bearish tell, if we interpret the higher implied volatility as an expectation on the part of options buyers for lower prices in the near future. That intuition hasn't always held up in cases where both SPX and VIX close higher, but either way, let's just look at the data:
The average S&P 500 returns one day, week, and month later have been flat, so it doesn't look as if these situations are predictive of anything over the short term. The 11% return in the last column occurred after a signal on March 13, 2009, just a few days after the March 6 "V bottom." Another recent signal on October 29, 2007, occurred just before a 9% market decline, noted on the chart below.
Click to enlarge
Again, the average result after days where the equity and volatility indexes all close higher doesn't seem to offer any reliable edge, so bulls and bears should both resist divining meaning where there may be none.
However, what if we look for instances in which both equity and volatility indexes closed higher on a weekly basis? Since 2004, that's happened just 6 times, including last Friday, July 31. Results here are a bit clearer:
The average return is positive across all periods, and the upside range is much larger than the downside. It would be silly to give much weight to the results of just 6 cases, of course, but I do find it interesting that the historical tendency runs so counter to the conventional wisdom about the relationship between equities and their volatility index counterparts. The "smart money" might very well be loading up on puts here, but in the past, this particular indicator hasn't presaged anything catastrophic over the short term.
If forced to speculate about the cause of last week's movement across the indexes, I'd guess that the uptick in implied volatility could just as well be caused by a surge in call buyers chasing returns as by traders hedging to protect gains.
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