Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Analyzing the Relationship of Equity and Volatility


Indexes are highly correlated but diverge every day.

Although the major equity indexes are highly correlated, they tend to diverge in meaningful ways on a day-to-day basis. The same is true for the implied volatility indexes that track equities. It's also common for equities and implied volatility to move inversely on a daily basis -- the expectation is that, most of the time, if the S&P 500 (SPX) closes up, the VIX is likely to close down.

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.
< Previous
  • 1
Next >
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.







Featured Videos