Vol Whisperer: Mean Reversion—What It Means or Doesn't Mean

Do you know how to measure mean reversions? It's a popular investment strategy used by market traders around the world. Find out how you can use it.

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Implied volatility, and the CBOE Volatility Index (VIX) in particular, have become popular topics among traders and investors. In volatility (“vol”) discussions, one specific term has been gaining currency: mean reversion.

Mean reversion, in relation to vol, refers to situations where, most of the time, vol sticks pretty close to some average (mean) level. And when vol deviates from that mean—higher or lower—it has a tendency to move back, or revert, toward the mean (reversion). For example, most of the time VIX moves around some average, say, 13. Sometimes it might jump up to 17, but then settle back down around 13 again. Should the VIX drop down to 10, it might rise back up again to that 13 average. In other words, thanks to mean reversion, VIX tends to oscillate around an average price.

Options Trading Lens

Mean reversion describes a kind of cyclical behavior, but it’s not as precisely defined as some other cycle analyses. In fact, mean reversion, as a concept, exists only in the trading world. You might see it referenced in social science, but you won’t find it in a statistics book. Also, there’s no widely accepted metric to quantify mean reversion. Compare that to pricing options with Black-Scholes–based complex models. 

In other words, vol’s mean reversion is really in the eye of the beholder.

In fact, implied vol doesn’t have a single constant average. It may move in a narrow range for days or weeks. But then an event shakes the market that could send it higher, where it might oscillate around a new mean for a time. Or vol might sink to a lower level because of market confidence or complacency, and it might oscillate around that lower average for some time.

When looking at longer time frames, in recent years, mean reversion to the downside has been observed. That’s when the VIX rises, say, for several days on unexpected world events like Brexit, and then sinks down to a lower level, where it may remain for weeks or even months. 

One of the clearest examples of vol’s mean reversion is centered around earnings or news events. Implied vol has a tendency to rise ahead of uncertainty, which could mean an important earnings announcement for a stock or an upcoming FOMC meeting. Once earnings come out, the uncertainty is over, and vol may drop. This can happen whether the news is good or bad, or even if the stock in question rose or fell. But it doesn’t always happen that way.

Conceptual, But Useful

For the time being, until we figure out a way to effectively measure mean reversion, treat vol’s reversion as a potential confirmation of your existing strategy. You might consider using a long vega trade if you think vol is low and could revert higher, or a short vega trade if you think vol is high and could revert lower.

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Thomas Preston is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

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