It seems that ever since the CBOE Volatility Index (VIX) first achieved notoriety about a decade ago, a cottage industry of over-analysis has grown up around it. We parse every little tweak as if it bears some sort of predictive power. “VIX is up too much.” “VIX isn't up enough.” “Why isn't there more fear out there?” “Why do I keep asking rhetorical questions about an index?” And while I've overhyped and overanalyzed the small moves as much as anyone, it's worth stepping back and seeing the bigger picture through a new criterion—regime.
Horizons Are More Than Sunsets...
Volatility moves tend to produce more “noise” than signal in the short term. But expand your time horizons and you might see clearer trends. VIX tends to move within “high” and “low” regimes—ranges across larger subsets of time—that last between 4 and 6 years. Right now, you could make a case that we're about two years into a low VIX regime. But, at the end the day, what does that mean?
Look at the monthly chart of VIX from 1993 through the end of 2008 in Figure 1.
The horizontal line in the chart is drawn at 20 because that's more or less the average level of VIX over the course of time. Prior to 1997, VIX broke above 20 infrequently. Back then, no one talked about the VIX. But we did follow volatility trends. Since the markets went up pretty much every year in the ‘90s, we treated implied volatility as a stable variable. If it got a little elevated, you sold more options. If it got cheap, you bought them back. Mean reversion within a small range was the name of the game.
We'll call this Down Regime 1, lorded over by former Fed Chairman Sir Alan Greenspan and Sir Eddie Vedder.
By 1997 though, implied volatility started to trend up. And so did the market— the only time in the last 20 years that the VIX and the equity market seemed to move in the same direction. It was the dawn of the tech bubble, day trading, and eye-popping rallies in stocks that either don't exist anymore (anyone remember eToys?) or are a shell of their once high-flying selves. (Here's looking at you, JDSU.)
That legendary stock rally may have ended in March 2000, but the volatility rally persisted until mid-2003. The 20 line that served as a ceiling in the ‘90s now looks more like a floor, as the millennium turned over.
We'll call this Up Regime 2, patron Saints of Jeff Bezos and Derek Jeter.
From mid-2003 to early 2007, VIX troughed again, thanks mainly to a persistent and non-volatile market rally, followed by the persistently strong VIX that started in roughly February of 2008 and ended, well, we don't know for sure yet, though a new “low” regime likely started around the beginning of 2012.
Heed Your Definitions
What does it all mean?
Well, nothing. And everything. Remember that the VIX reverts to its mean. However, the trick is to define “mean"—hence the need to look at regimes. Yes, 20 may be the long-term average VIX, as you can see from the charts. But a trader can go broke waiting for it to revert back. The true mean is more local.
If we're truly in a “down” VIX regime, than we have to recalibrate expectations. Whereas 20 VIX maybe was cheap a couple years ago, it's now on the high side. Readings in the low-to-mid teens may prove to be our “new” normal. This doesn't mean we won't see 25 VIX again, and watch it stay there for a couple of years. But seeing as how we're at historical lows, keep your eyes peeled for a rise to a new regime.