Data suggests that right now there is nothing out of the ordinary in how the VIX reacts to market moves
Last Wednesday, the S&P 500 Index (SPX) fell over 2% after closing near an all-time high the previous day. The Cboe Volatility Index (VIX), which measures implied volatilities in SPX options and is often viewed as a measure of fear for the markets, rose over 25% on this move. It was touted as a significant step for the VIX, but it made me curious what kind of response you would expect from the VIX in such circumstances.
In line with expectations
This scatter plot gives us an idea of what kind of movement we would expect under the circumstances of last Wednesday. In particular, since the financial crisis, I’ve looked at the SPX to be within 2% of an all-time high, with the VIX at 20 (+/- 5 points). Then I just plotted the VIX returns against the SPX returns. The green trend line shows what to expect when stepping up the SPX. This circled red dot is the action from last Wednesday. You can see that it’s not too far above that green line. Also, when you hit more than 2%, the VIX tends to move higher than the trendline suggests. I would conclude that the VIX was expected to move on that day, given the circumstances.
The red points in the illustration are the more recent measured values. There does not seem to be any bias on the green trendline one way or another. It suggests that there is nothing out of the ordinary in terms of the VIX’s response to market moves right now.
VIX reactions as an indicator
In the analysis above, I had to consider whether there might be an indicator in these VIX responses. My theory would be that if the VIX rises more than expected under the circumstances, it indicates fear in the market. The contrary assumption would be that the VIX surge would lead to bullish stock returns going forward.
To determine if this is a workable indicator, I looked at the same returns as in the analysis above. Remember, these are cases where the VIX is between 15-25 and the SPX is within 2% of an all-time high. The expectations of the VIX response would change depending on the market environment. Then I measured how far the VIX return was from what one would expect (the distance between the point and the green line in the table above). The first table below shows how the SPX performed when the VIX response was way above expectations. The second table shows the SPX returns after the VIX response was much lower than expected.
Granted, since the VIX is a measure of the expected volatility over the next 30 days, I’ve viewed this as a short-term indicator. In the short term (two-week and one-month returns) the SPX underperformed when the VIX spiked larger than expected. This is the opposite of my theory. However, the indicator does much better in the long term. Looking at the six-month returns, where the VIX spikes are much higher than expected, the SPX gained nearly 9% on average, with an impressive 96% of returns being positive. If the VIX response is lower than expected, the index will gain 3.3% on average, with 75% of returns being positive. Perhaps the turmoil in the options markets is a better longer-term indicator
If there is a viable indicator here to add to the arsenal, it will require a lot more study. The fact that the bullish returns are taking so long to kick in (the returns are bearish for a month) makes me pause to think about it for now. For completeness, the following table shows how the SPX performed in line with expectations after the VIX response.