Under the Hood: Understanding Volatility and the VIX, Pt. 1

Because of the close relationship between the price of an option and the price of the actual stock, the VIX should provide an accurate measure of future volatility. In the chart above, each point labeled corresponds to a spike in the VIX. Notice that each time the VIX spiked, the S&P 500 declined. This indicates that the VIX and the S&P 500 have a very strong tendency to move in opposite directions. This is confirmed by the correlation between the two, which is -0.57. I suspect this negative correlation is much stronger when the VIX spikes as opposed to when it falls. 

Does the VIX Provide an Early Warning Signal?

Discovering a tool which can identify a stock market correction, in advance or in the early days of the correction, is akin to finding the Holy Grail of investing. Can the VIX forewarn investors of an impending downturn?

To analyze this, I divided the chart into five phases marked P-1 through P-5. First, a few observations are warranted. The middle phase (P-3) is the period which experienced the greatest volatility. In fact, the VIX hit its all-time high of 80.86 on November 20, 2008 which was during P-3. To gain a more thorough understanding, let's refer to the following table.

The table includes relevant information for each phase, including the time period and the high, low, and average VIX. For example, P-1 began on 1/1/2005 and ended on 2/26/2007. During this phase, the VIX averaged 12.67, ranging from a high of 23.81 to a low of 9.89. Using the information in the table we can make a few observations. 

First, the average VIX during P-2 was nearly 63% greater than the average VIX during P-1 (ex: 20.65 versus 12.67). Similarly, the average VIX during P-3 was a staggering 122% higher than its average during P-2 (ex: 45.82 versus 20.65). The point? There was a substantial rise in the average VIX leading up to the market crash. But was it enough to forewarn investors? Let's examine this using the closing values of the S&P 500. 

The index reached a record high of 1565.15 on October 9, 2007 during P-2. By the end of P-2, slightly over 10 months later, the index had fallen to 1282.83. This represents a decline of 18.04%. Although this is significant, the index was not in official bear market territory….yet. The worst was still to come. From the end of P-2 until the index finally bottomed on March 9, 2009, the S&P 500 lost an additional 47.26%, for a total loss of 56.78%. Did the VIX provide an early warning? Were the lights flashing red? Let's take another look at the chart.

Let's compare each phase. Note how the VIX was very calm in P-1 with only one exception (point A). The average of the VIX during P-1 (i.e. 12.67) was much lower than its long-term historical average of 19.61. In P-2, the VIX spiked multiple times, represented by points B-G. The spikes in P-2 are reminiscent of tremors prior to an earthquake.

In P-3, the worst period for volatility, there were several spikes but I only labeled one (H). Following P-3, we can see how P-4 was also elevated and was similar to P-2. We can also see how P-5 was quite low and very similar to P-1. In fact, upon closer inspection, it is interesting to see how P-5 and P-1 only have one spike and how closely they resemble each other. Are we heading into another P-2 period? 

In the phases farthest from center (i.e., P-1 and P-5), the average VIX is well below its historical average. The phases adjacent to the middle phase (P-2 and P-4) are alike in that they are both elevated. P-4 is the period of the flash crash which occurred in May 2010 (point I) and the stock market correction in 2011 (point J). 

Conclusion

We've covered the VIX from several angles. We learned how it works, discussed its relationship to the broader stock market and saw how it fluctuated in the months leading up to the worst period of volatility in the financial markets since the Great Depression. Did the VIX provide a warning?

Moving forward, I believe the VIX will become more widely utilized. In the second article in this Under the Hood series, we'll look at some ETFs that are attempting to track the VIX.

We'll see how well they're doing and discuss the risks involved in these types of investments.