Thursday, October 30, 2008

Recent Volatility and VIX Macro Cycles

The science art of forecasting volatility more than a couple of weeks out has always struck me as a lot more like astrology than astronomy, so it was with some mild apprehension that I thought I should update my VIX macro cycle chart here and see what previous posts in this area predicted for 2008.

The good news is that in December 2007 in Was 2007 the Beginning of a New Era in Volatility?, I managed at least to nail the persistence of the recent trend by noting, “the current rise in volatility should persist through all of 2008, even if the rate of rise in volatility begins to slow.” In what looked like a much safer prediction, I said, “the rate of change in volatility over the course of 2007 is unsustainable going forward – or at least inconsistent with the slope of volatility macro cycles during previous cycles.” As the monthly chart below shows, the VIX essentially moved sideways to down from July 2007 through August 2008, at which point the recent volatility began in earnest.

My most recent VIX macro cycle update comes from March 19, 2008, just three days after Bear Stearns was sold to JP Morgan (JPM). At that point in time many believed volatility seemed to understate the gravity of the financial turmoil. For historical context, I will repeat my assessment at the time:

I still anticipate that volatility will spend a good portion of 2008 in the neighborhood of 22-26. Looking at the current VIX futures quotes, where the May through December futures are all trading just below 26, it looks as if my prediction is on the low end of the market consensus.

The big question I have is about the duration of current VIX macro cycle – and of course the slope of any continued increase in volatility. If the current slope of the volatility increase holds and the minimum cycle time is two years, that would project to a sustained VIX of about 40 by the end of the year. I don’t expect to see that scenario unfold, but it will be interesting to see how long it takes for the runup in volatility that started about 15 months ago to run out of steam.

So…7 ½ months later I can say that my prediction held up through mid-September, but once Lehman Brothers filed for bankruptcy, the LEHVIX and VIX went through the roof and my predictions went out the window.

From a macro cycle perspective the two questions to ask now are how long the current cycle of increasing volatility should last and what direction the next cycle will take. Using the historical norms of a 2-4 year cycle and considering the steep trajectory of the recent 22 months of increasing volatility, I suspect that the current cycle is nearing an end and either topped out at the beginning of the week or will see one final topping move in the next month or two.

The direction of the next move is the bigger question and the more difficult one to answer. Two of the three previous changes in volatility have ended in a multi-year sideways move. Given some of the structural and fundamental challenges currently facing the economy, the easier prediction to make seems to be several years of elevated volatility.

I am going to go out on a limb, however, and stick to my fear bubble thesis to predict that volatility will be on the wane over the course of the next two years or so. Don’t succumb to anchoring when it comes to a VIX of 70. Just two months ago the VIX was in the teens. While it may be awhile before the VIX returns to the teens, I would not be surprised if the VIX were back in the 20s in another 2-3 months.

Of course, a large part of the path forward will be strongly influenced by the policies and regulations put into place by governments that have yet to take office – all of which substantially increase uncertainty around any prediction.

[source: StockCharts, VIX and More]


iv said...

I am new to understanding VIX....but a stupid question is

Does a VIX in 20's in 2-3 months mean a much higher markets for sure or not?

Thanks for an interesting blog!!!

Bill Luby said...

Thanks for the comment, IV.

A VIX in the 20's in 2-3 months would probably mean a 95% chance or better that the markets are higher than current levels.

There are no guarantees, of course, but there is a very strong negative correlation between the VIX and the markets.



Anonymous said...

Bill, first i'd like to say I read your blog everyday and find the information you post, and the subsequent comments, very educational and though provoking. I have a question for you regarding the hedging of the vix options using the front month futures. I am an active options trader and have attempted to use the spy etf as a hedge against my front month vix options with mixed results. I know you have posted here resrearch results regarding the inverse relationship between the spx and the vix spot price. Furthermore, you went on to note that the perceived .75 negative correlation seems to break down when there is a larger than three percent move in the spx. Needless to say, three percent moves are almost a daily occurrence as of recent and and this relation ship rarely holds... although there is a definte correlation.

This brings me to my question: since the vix options are priced using the front month futures price more so than the spot vix, is there a correlation you have noticed between the SPX and the front month vix futures movement which may create a more accurate hedge for my vix options?

observation: since the spread has now widened tremendously between he front month futures and the spot vix, I believe the lack of integrity for the spx-spot vix hedge when the market moves more than 3% is simply because the front month futures usually would move with much less magnitude and, thus, give the appearance that the correlation was not reliable. However, in fact, there may be a much more reliable correlation with the vix front month futures price. In retrospect, attempting to hedge according to the spot vix price instead of using the front month futures as the underlying may have led to my mixed success-- namely on high volatility periods. before I jump back again the Vix options full steam, I would like to see if you, or another blog reader, could shed some light on the subject. Thanks guys.

Anonymous said...

To be more clear, my hypothesis for the SPX-vix correlation is the following: the observed relationship between the VIX and the SPX is actually the correlation between the SPX and the front month VIX futures. Since, the spread between the futures and the spot has historically been small, this discrepancy was only evident when the spread bwtween the vix spot and futures widened-- namely on volatile market days.

Bill Luby said...

That is an interesting hypothesis and question, Mike.

I would probably have to run some numbers before I could give your question the answer it deserves -- and I'm afraid that is something I probably won't get around to until next week at the earliest.

In the interim, I thought I'd throw another data point into the mix for you, the VIN (CBOE Near term VIX), which tracks the VIX calculations only for the front month of the SPX options used in the VIX calculations. Today these have 19 days until expiration (the index will roll to the next month at 8 days until expiration.)

Unfortunately the CBOE doesn't yet publish information about the VIN, but you might want to seek out the historical data (it was launched on 8/25/08) and see if it adds another piece to the puzzle.

I'll see if I can get a better answer for your question; I hope this helps for now.



Anonymous said...

Bill, thanks for getting back to me and I look forward to seeing what you think next week. I was not aware of the VIN and I will definitely try to get some data on that. Keep up the great blog.


Anonymous said...

Mike, Bill,

the rolling 22-day (Pearson) (negative) correlation between the *cash* VIX and the S&P 500 is regularly between -0.75 and -0.99 (since 2/1/1990 on 50% of all 4,746 trading days, and between -0.50 and -0.99 on 75% of all trading days). The rolling 22-day (Pearson) correlation between the VIX front month future and the S&P 500 is very high as well, but almost always at least -0.10 (regularly more) points less than the correlation between the *cash* VIX and the S&P 500.

The main reason is that the VIX front month future contains a mean reversion factor, which plays the heaviest role the last trading days before settlement. e.g. although there may be a very strong S&P 500 and a correspondingly decreasing *cash* VIX in the days before the VIX future settlement day, but if the VIX front month future showed a huge negative premium versus the *cash* VIX, we may see no movement at all in the VIX front month future or even an increasing VIX front month future instead (closing the negative premium) which would have a negative impact on the correlation between the S&P 500 and the VIX front month future (while the correlation between the *cash* VIX and the S&P 500 works well).

Best regards

Anonymous said...

"I would be very surprised if the VIX were not back in the 20s in another 2-3 months."

I don't believe that's likely. I believe VIX decreases in value far more slowly than it rises.

I'd (theoretical cash only) wager that it won't dip below 30 (for more than a couple of days) through 2009.

Anonymous said...


actually i would be very grateful with the vix around 30 to 40, which i believe will be the norm for some time

Anonymous said...
..hard to brek 1.15 area.
BEST REGARD, valerio (from Italia)

garibaldi.g said...

Since 27 Oct VIX/VXV didn't break that support.

Anonymous said...

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