“This time it's different.” How often do you hear that? Yes, the world may change, but not the behavior of volatility. Volatility generally moves up and down. It can spike every once in a while due to macro events, but then eventually trades in a new range. The trick is understanding when the new range has been formed.
Let's take a look at the CBOE Volatility Index (VIX). The VIX proxies volatility of an SPX option with 30 days to expiration. Since the mid-1990s, VIX has traded around a mean of 20. But break it down a bit, and it tends to fluctuate between strong and weak three-to-five year regimes. For example, VIX hovered in the teens in the early-to-mid 90s—a weak regime. When the tech bubble came in the late 90s, VIX generally traded in the 20s—a strong regime. In 2003-2007, VIX weakened and traded mostly under 20. Recent years—strong. And so on.
Charting the New Normal
So how do you know when VIX has left one regime and begun another? We don't know. Nobody knows. But we do know that over time, VIX is a mean-reverting instrument. So the real trick is finding a fair mean in the here and now. This is where charts can come in handy.
Bollinger Bands is a tool you can use to help define “new” normals. Figure 1 shows a six-month thinkorswim® chart of VIX, with Bollinger Bands.
The green line in the center is the 20-day simple moving average, and the two outer bands (pink lines) are set two standard deviations up and down (i.e. 95% of the price action). The chart covers a six-month stretch that really encompassed two “mini-normals.” From April to July, 2011 VIX fluctuated in the 15-21 range. Then came the fears around a European collapse in August, 201 and the ensuing VIX pop. Afterward, a new range formed, from the low 30s to the high 40s.
A couple things should stand out. First, in short time frames, VIX has previously tended to bounce around the moving average, unlike stocks that can trend and trend. And this mean reversion can happen during periods when VIX is both strong and weak. Second, the moving average hasn't always sat in one area for long. It can get comfortable in one range then—wham!—it moves into another.
It's easy to lean against a range, like the one from April to August, 2011. And it's even easier to get caught leaning against the top of that range, then watching it go far beyond that. Flexibility is the key here. VIX has no “fair” value. It's forever worth the price the market places on insuring a portfolio, and the aggregate investor sentiment regarding future market risk. So when the notion of a price changes over time, you might be wise to change your notion of that price, too.
Even if you're not trading options, being flexible still applies. Consider adjusting your stop losses, widening your targets, and reducing your position sizing as market volatility increases. It's less about guessing when “facts on the ground” will change, and more about adapting swiftly as it happens.