Volatility, and more notably, the Volatility (or “fear”) Index (VIX) is often discussed, but not widely understood by many traders and investors. The VIX is trotted out on financial news networks when the market sees outsized swings in price, but is put back in its box once a stock or index returns  to its normal trading range. However as traders and investors, we can gain a great deal of knowledge about the state of the market from the Volatility Index ahead of large moves in equities.

Because volatility can be a difficult topic for some to grasp, it’s often oversimplified in order to be understood. It’s why many believe sweeping axioms like “low volatility is what leads to high volatility” and “large negative VIX declines precede large VIX advances”. Unfortunately, these beliefs don’t always hold up in the real world; plus, this way of analysing volatility is a poor method of forecasting spikes and with it, managing portfolio risk.

In my paper, ‘Forecasting a Volatility Tsunami’, I dig into three methods for analysing volatility ahead of large spikes in the VIX, specifically: when volatility is low; when it has experienced a large decline; and finally when its daily movement has contracted. Research by Alessandro Cipollini and Antonio Manzini in 2007 showed that elevated volatility has provided value in forecasting three-month returns in the S&P 500, but the same doesn’t hold true when volatility is low. Volatility was stubbornly low for the bulk of 2017, and provided an excellent example of this. It meant that traders who view volatility as a trading signal were provided with many false positives in expecting a large advance in the VIX Index.

Instead, what traders should be more focused on is the daily degree of movement in the VIX. Hyman Minsky famously said, “stability leads to instability”, which applies to the VIX in describing its state before material rises. And I’ve found in my own research and analysis that when the daily dispersion of volatility (when there is little movement within a string of days and the range of movement is narrow) begins to contract to historically low levels, and so creating a perception of market stability, an environment is created for volatility to spike higher, and often with it, equities to move lower.

“Dark clouds do not always produce storms, but rarely does a large storm come without the clouds darkening first”

While I do not believe that volatility dispersion alone provides enough insight to act as a trading signal, it does afford a great deal of clarity in the level of risk-taking (or lack of) being shown in the markets. Indeed, the largest moves in the VIX have nearly all begun when volatility dispersion (as measured by standard deviation) was extremely low. This provides an environment that traders can watch out for to better prepare for possible spikes in the “fear index”.

It’s important to note that not all periods of low-volatility dispersion have led to large spikes in the VIX, but low dispersion has nearly always come before spikes. It’s like dark clouds forming before a thunderstorm: the clouds do not always produce storms, but rarely does a large storm come without the clouds darkening first. By monitoring when volatility activity begins to tighten, traders can potentially better manage investment risk exposure and use it as a lens to identify possible changes in the financial environment.

 

BIO
Andrew Thrasher
A holder of the Chartered Market Technician designation from the CMT Association, Thrasher was the winner of the Charles H. Dow award in 2017 for his paper, ‘Forecasting a Volatility Tsunami’. He serves as the portfolio manager for Financial Enhancement Group LLC, a wealth-management firm in Indianapolis, Indiana, and is also the founder of Thrasher Analytics LLC, an institutional research firm.