Friday, February 2, 2007

The VIX and 3% SPX Drops

What happens to the VIX when the SPX drops 3% in one day? Does the VIX provide any advance warning of a selloff or merely serve as a contrary indicator after the fact?

Since 1990, there have been 25 instances in which the SPX has fallen 3% or more in one day. In analyzing those movements, it is important to remember that volatility has a strong tendency to cluster; as a result, a majority of the data points I looked at happened to fall within the same month and many were during the same week as another 3% drop. This should not be surprising, as almost all of the SPX plunges from the last decade have been triggered by the Asian financial crisis (including the spillover into Russia and Brazil) and the unwinding of the dot com bubble.

The following graphic depicts a composite view of changes in the closing price of the VIX on the 25 occasions from 1990 to the present in which the SPX has dropped 3%:

Note that the scales fixes the close on the day before the 3% drop at 100, so that percentage moves to and from that point are easier to calculate. It is worth highlighting that while the actual values of the VIX are not included here, only twice during this period did the SPX drop 3% with VIX values already below 20. In fact, the median value for the VIX prior to the SPX drop is 31.21, again partly reflecting the clustering of volatility that results in multiple sharp drops in the SPX.

On average, a drop in the SPX of 3% or more translates to a 14.3% spike in the VIX. More than half of the time, the day of the SPX 3% drop turned out to be the high in the VIX over this 11 day period. On average, half of that spike is retraced within two trading days and over 70% of that move is retraced in five days.

In future posts, I will discuss in greater detail the issue of the VIX providing advance warning of a selloff in the broader market. Suffice it to say that while the graph above shows that the VIX does jump approximately 10% in the four days before a 3% SPX move, there is not the obvious telltale movement in the day or two before the selloff that might get the attention of the casual observer.


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