Periods of low volatility can last months and even years. When it happens, it has important implications for investment and options strategies.
Sometimes the equities market can sink into a low-volatility funk that can last for many months or even years. One example from recent history is a two-year stretch that started in April 2004, when the CBOE Volatility Index (.VIX) moved beyond the 20 “psyche” level only once and even fell very near record lows when it dropped to 9.39 by late 2006.
These longer-term periods of relatively quiet trading are obviously not a bad thing. They might simply warrant somewhat different investment or options strategies compared with periods of high volatility. And although it’s impossible to predict what comes next, there is one objective indicator that can help make sense of what has happened in the past: historical volatility.
VIX fell to 2016 lows less than a month ago when it touched 12.50 on April 20. The indicator, which tracks the expected or implied volatility priced into a strip of S&P 500 Index (.SPX) options, has since rebounded into the mid-teens. However, as we can see from figure 1, the index has fallen sharply from its early 2016 highs and has been mostly in a range between 13 and 16 over the past few months.
FIGURE 1: VIX.
CBOE Volatility Index is moving off the 2016 lows from late April. Source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
Because VIX tracks implied volatility, it typically moves higher when there is an uptick in risk perceptions among investors. That’s because increased demand for SPX puts to hedge portfolios can cause the premiums to increase, just as insurance companies can charge higher premiums for policies in the wake of a natural disaster. Consumers are more willing to pay more for the protection in times of greater anxiety and uncertainty.
VIX, which is updated throughout the day and even after hours, is the measure of how much the premiums for portfolio protection are changing. It’s a tool for understanding what investors expect for the future. The index is called the market’s “fear gauge” because it ticks higher when investor anxiety levels are on the rise. Although it measures only the implied volatility of options on the S&P 500, other VIX-like indexes have been created to track a variety of other markets, such as gold, oil, and even the volatility of volatility. You can find more detailed discussions of them in previous installments of the Volatility Update.
Importantly, the daily meanderings of VIX and other measures of implied volatility don’t always reflect what is actually happening with the underlying instrument. Sentiment has an important role in driving these volatility barometers higher or lower. There’s a better tool for calculating real, historical, or actual volatility. Called statistical volatility or historical volatility, it is computed as the annualized standard deviation of closing prices over a specific period of days.
For instance, the 20-day historical volatility of the S&P 500 fell to a 2016 low of just 8.7% last Thursday. That, in turn, marks the lowest number since June 2015 and simply means that, when looking at the closing prices of the S&P 500 over the past 20 days, the daily moves are getting smaller. Real volatility is dropping.
Going one step further, figure 2 shows the difference between VIX and the 20-day HV of the S&P 500 over the past 16 months. With VIX near 16 and actual volatility of 8.7%, the difference is 7.3 points and the second highest this year. The highest was from January 8, when VIX was at 27 and actual volatility was 18.8%.
FIGURE 2: VIX VERSUS 20-DAY HISTORICAL VOLATILITY OF THE S&P 500.
Data source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.
Over time, implied volatility (IV) and actual volatility shouldn’t deviate too much on the same underlying security, or the options might be mispriced. If IV is too high, the premiums are possibly too rich and vice versa. That helps explain why extremes in figure 2 are followed by extremes in the opposite direction, as reversion to the mean corrects any short-term imbalances.
The challenge, of course, is forecasting future volatility, because it’s unpredictable. The point to take home is that market volatility can often sink into a lull that can last many months or years. Moreover, while VIX on April 20 might have seemed extremely low, with actual volatility now falling below 9 today, that no longer seems so crazy. In fact, at 12.5, the index actually underestimated how much actual volatility would fall.
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