Introduction:
Statistically, volatility is related to the movement of both positive returns and negative returns. In the context of the equity markets, volatility is often discussed when stocks decline. When they decline, volatility indices such as VIX, VOLQ, and VSTOXX (V2X) will often rally as they all have a negative correlation to their underlying equity market.
The underlying equity markets for the VIX volatility index, the VOLQ volatility index, and V2X are the S&P 500 (SPX), the Nasdaq Composite (NDX), and the EURO STOXX 50 (SX5E), respectively.
The daily correlation of VIX, VOLQ, and V2X relative to its underlying market from January 2, 2014, to July 29, 2022, is -0.73, -0.73, and -0.76 respectively[i]. They all have strong negative correlations to their underlying markets, however, it’s not a perfect negative correlation, and thus when equities decline, the volatility indices will not automatically rally. On a day-to-day basis, the markets can be noisy. A volatility index can rally when its underlying market rallies. And sometimes volatility indices won’t rally when equities decline.
However, when large macro events, the so-called “shocks to the system” events or left tail risk events occur such as the Financial Crisis in 2008, COVID in 2020, and inflation and the invasion of Ukraine in 2022, volatility indices usually rally.
The volatility indices are sentiment indicators as they are based on option prices of their underlying markets. Therefore, the volatility spot markets may offer a market view of options traders.
Figure 1: Daily Closing Spot Prices July 17, 2017, to July 29, 2022
Source: Bloomberg
Common Behavior of Volatility Indices:
As noted in Figure 1, when diagnosing the general behavior of the volatility indices, below are some common items that often occur:
- The volatility indices tend to spike quickly.
- After spiking, the recovery back to the bottom support prices may take weeks, months, or longer as volatility slowly drifts lower. When volatility spiked in 2020 due to COVID, VOLQ did not fall below 15 until August 2021. That was the bottom of the move.
- When the index sits at its lows for an extended period, the underlying equity market continues to move higher with very few corrections along the way. This may increase the probability that the volatility indices will have a larger rally. I call this the “Compressed Spring Effect” because the extended lows are similar to compressing a spring. The more the spring is compressed, the larger its bounce once the compression stops. 2017 was a great example of this as the equity markets continued to move higher, volatility priced at the lows for extended periods in 2017, followed by an equity correction in early 2018.
Equity market downside volatility may experience cycles of high volatility and low volatility. Figure 1 graphically demonstrates the downside volatility cycles of equity markets based on VOLQ. The tables in Figures 2 & 3 numerically suggest volatility remains elevated since January 2020. The average, median and minimum prices are higher since January 2020 versus the past six years and appear to be currently sustaining the higher volatility levels.
The COVID equity market decline in February and March 2020 could be considered more of a “shock to the system” as the equity markets quickly declined 28% over 22 days and recovered over the next 53 days. From the peak on Nov 19, 2021, to the current trough on June 17, 2022, NDX declined 32.8% over 143 days.[ii] The current market decline could be described as more of a slow downward grind of the equity markets due to inflation, supply chain issues, interest rate increases, the war in Ukraine, and talk of a possible recession in the not-too-distant future.
Volatility Support and Resistance Levels:
Figure 2: January 2, 2014, to July 29, 2022, Daily Closing Prices
Source: Bloomberg
Figure 3: January 2, 2020, to July 29, 2022, Daily Closing Spot Prices
Source: Bloomberg
Summary:
Understanding the behavioral tendencies of the volatility indices may give some insight into how they behave in different situations. With that historical understanding, the data suggests the markets have been in a higher volatility regime since 2020. Should we expect the higher volatility regime to persist?
[i] Source: Bloomberg data
[ii] Source: Bloomberg data
Past performance is not necessarily indicative of future results. There is risk of loss when investing. Only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Mark Shore
Mark Shore, a well-known expert on alternative investments with over 30 years of experience in the capital markets. He is currently a Clinical Professor of Finance at DePaul University, Executive Director of the Arditti Center for Risk Management, and Chief Research Officer of Shore Capital Research.
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