Understanding the nature of volatility regimes and recognizing when it’s shifting could help unlock potential trading opportunities.
There’s an old joke that says economists can’t predict a recession, but afterward, they can identify it and tell you why it happened. As a trader, you don’t look for potential opportunity in the rearview mirror but down the road.
Whenever the underlying fundamentals experience a drastic change, it can take a while to revert back. And sometimes things don’t fully revert but settle in to a “new normal.” It’s like muscle memory—a new regime might be taking hold, but the market is still focused on the last one.
If you understand the nature of vol regimes—and recognize when one’s changing—you might unlock some hidden trading potential.
If you look at the Cboe Volatility Index futures (/VX) curve from this past April and the two Aprils before that (see figure 1), you’ll find three different vol regimes. In 2019’s pre-pandemic world, the VIX had settled in to a classic low-vol regime—the curve was in slight contango (upward-sloping), with the front month in the low teens and deferred months in the 17s.
Then COVID-19 hit, sending vol higher. The curve in April 2020 was in steep backwardation—downward-sloping with the front month near historic highs. That reflected deep market uncertainty. But one year later, well after the market fully recovered and forged ahead to new highs, with the front-month /VX below 20, back-month /VX contracts were still hovering in the mid-20s in a steep contango-term structure.
How and when do regimes shift? It might help to look at the past and compare implied vol—up and down the futures curve—to the current historical vol (HV). Unlike implied vol (which is the market’s expectation of future vol), historical or “realized” vol measures the actual price movement over a period such as 20, 30, or 90 days.
On the thinkorswim platform, you can see how current HV ranks against the HV over the past year (HV percentile). Check it out for the VIX—or any stock—under the Trade tab > Today’s Options Statistics.
Is there a mismatch between the vol implied by the market and the actual observed price movement? If so, that could create potential opportunities—or at least a reason to sidestep certain strategies. For example, note the red curve in figure 1. That steep contango means, all else being equal, that options could lose extra vol steam from the two-months-out point. It’s called riding the curve, and if you’ve ever hit the slopes, you know the downhill run is easier than the uphill climb.
A final key to spotting a vol regime change as it happens: Follow the real-time action. Tune in to programming from our media affiliate, the TD Ameritrade Network, for up-to-the-minute market insights.
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