Friday, August 10, 2007

Fear vs. Volatility

Astute observers may have noticed several instances over the past few days where VIX tops and market bottoms have parted company. Part of the reason for this is that the fear component of the VIX has recently grown large enough that it has sometimes overshadowed the volatility component. We have a lot of volatility at the moment, but we have more fear than we have seen in a very long time.

It is difficult to decompose fear and volatility by looking at charts, but one worth examining is the ratio of the VIX to the SDS, which is the 2x inverse ETF of the SPX. The graphic below is a 10 day chart with 30 minute bars, with the SPX behind it in gray. It shows the type of mirror image you would expect between volatility and market movements up until the latter stages of Wednesday’s session. From that point on, the formerly predictable negative correlation becomes significantly muddier, to the point where today’s session shows the ratio way out of proportion to the market downdrafts.

Some of this decoupling is clearly traders buying puts to protect themselves against Monday’s headline risk, but I do not believe this is the entire story. As the markets have rallied during the course of the day, the VIX to SDS ratio has remained stubbornly higher, suggesting that the fear component of the VIX may now be the tail wagging the volatility dog. I will see if I can do a better job of coming up with graphical data to support my contention, but you can now see and feel the fear in the markets, even if it is not that easy to isolate it in the charts.


dk said...

Nice post. Yes, the VIX move has indeed been disproportionate to the underlying equity gyrations, and your chart shows it well.

One interesting theme is that the heightened fear has produced little genuine panic. We haven't seen any massive, 7-20% down days (thank heavens). The selling seems very genteel and organized. However, I often wonder if a spring is being wound here.

Ritholtz said...

I wonder if the issue with this decoupling is that the Fear is being generated primarily on the junk/high-risk fixed income side.

It spills over in a somewhat haphazard fashion to the equity side.

Unknown said...

Yes, the selling on friday was fear and speculative shorting. We are very close to a bottom with the added market liquidity from ECB and the Fed. Volatility should drop very soon. Small caps are beginning to stabilize.

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