In life, there’s perception and then there’s reality. For instance, you might perceive yourself to be the same athletic superstar that you were in your youth. But then there’s reality, when you can’t lift yourself out of bed the day after a one-hour workout at the gym.
In the world of volatility, there are perceptions and realities as well. In recent times, these perceptions and realities seem to be swinging more rapidly, from one extreme to another, than ever before.
VIX Slumps Back to Summer Lows
The reality last week is that the most widely watched measure of volatility crumbled. The CBOE Volatility Index (VIX), which is a measure of implied volatility derived from a strip of short-term S&P 500 Index (SPX) options, dropped to just 12 Thursday after the Federal Reserve, as widely expected, left rates unchanged at the conclusion of their September 21 meeting. VIX slipped 2.43 points Wednesday and then shed another 1.28 points the day after.
As you can see in figure 1, the two-day decline erased any gains scored in mid-September. In fact, at 12.02, the index was down 1.40 points month-to-date and a far yodel from the 20+ readings seen briefly on September 12.
Back to Reality
Although VIX fell sharply, actual market volatility did not fall by much. The average daily move in the S&P 500 in September is 13.4 points (through the first 15 trading sessions), and that compares to average daily moves of 8.6 points in August and 7.6 points in July. In other words, actual volatility has been much higher in September compared to July and August.
Consequently, 20-day historical volatility (HV) of the SPX remains somewhat elevated at 13.5% and substantially higher than the readings at the start of the month, when it fell below 5%. In addition, at 12, VIX is 12% below actual volatility. Rewind just a few weeks to September 8, and VIX was more than 150% greater than 20-day HV. As you can see in figure 2, VIX minus 20-day actual volatility went from very high to negative in a very short amount of time.
I wondered how often this happens, that VIX would be 150% greater than actual volatility, but then fall below it during the same month. It turns out, looking back more than 10 years, the only other times it happened were in December 2014 and then again in June 2016 (and it also came close in April 2010). Therefore, over the past decade, it has only happened three times, and two of those were in 2016.
VIX is a measure of implied or expected volatility of SPX options. It tends to be forward looking and reflects investor risk perceptions. Historical volatility, on the other hand, is a strict measure based only on closing prices. It reflects reality. VIX and HV are rarely equal, and the divergences can reach extremes. Recently, it seems the divergences are going from one extreme to another more rapidly than in the past. That is, as noted last week, volatility seems to be getting a bit more volatile!
This whippy action is neither good nor bad, but simply seems to reinforce the idea that it makes a lot of sense to take a longer-term, bigger-picture approach, rather than attempting to time or predict every short-term move markets might make.
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