Schaeffer's Trading Floor Blog

Is Small-Cap Volatility Contagious?

Using Bollinger Bands to gauge volatility on SPY, VIX, IWM, and RVX

by 7/16/2014 8:32 AM
Stocks quoted in this article:

How about we look at volatility through another lens, that of Bollinger Bands? This indicator is similar to historical volatility (HV), but it picks up more of the net moves. HV won't be able to distinguish much between a daily 0.5% rally in an index and a 0.5% range in an index that offsets itself day after day (i.e., goes nowhere over time). The Bollinger Band width will pick up the net move, however. And that does matter.

Let's say you're a net options seller and you choose to use short strangles and then hedge unaggressively. If the index moves a small amount each day -- but in the same direction every day -- you may ultimately lose on the trade, even though you probably sold the options at a "good" implied volatility (IV). By "good" I mean that the IV was higher than the HV that transpired. In contrast, if the muted HV was also directionless, you did great.

And that's where Bollinger Bands can help us out, as the widths will contract if the index stays more range-bound.

The Bands are also good to spot mean deviations from the volatility indices, similar to how we just use simple moving averages (SMA).

I used the standard 20-day SMA as the basis, and 2 standard deviations as the Bands.

Anyway, it remains a tale of two volatility worlds: Big and Small. Here's SPDR S&P 500 ETF (SPY) this year (click chart to enlarge):

YTD chart of SPY with Bollinger Bands
Chart courtesy of TD Ameritrade

Well, it looks exactly how it feels. The Band Width (bottom of graph) is at the 2014 lows. Since the May pop, the SPY has pretty much channeled between the 20-day and the upper Band.

And here's the CBOE Volatility Index (VIX) (click chart to enlarge):

YTD chart of VIX with Bollinger Bands
Chart courtesy of TD Ameritrade

The VIX itself is modestly more volatile. It hasn't closed outside the Bands since April, but at least it flashes into the upper channel. In fact, it sits there right now.

As we noted yesterday, some of this is a little misleading. The VIX got inordinately low thanks to the calendar, so all we've really done here is normalize to the fact that we're now open every weekday for a while, and earnings are due out all over the place. So it's still a very muted volatility picture, as far as big-caps are concerned.

It's very different when looking toward small-caps. Here's the iShares Russell 2000 Index (ETF) (IWM) (click chart to enlarge):

YTD chart of IWM with Bollinger Bands
Chart courtesy of TD Ameritrade
The Bands are widening as we tank yet again. And we're at the lower Band already.

And Russell volatility has sprung to life as well, as measured by the CBOE Russell 2000 Volatility Index (RVX) (click chart to enlarge):

YTD chart of RVX with Bollinger Bands
Chart courtesy of TD Ameritrade

That down channel in RVX was so "June." We're spiking above the widening Bands here.

So we do have volatility expansion, it's just about where you look.

The question is, of course, which side will win. Will small-cap volatility spread to big-cap, or is this just another blip that will settle down? Tough to know for sure, there's no particular precedent of small-cap volatility leading into any sort of permanent big-cap volatility trend change.

I would make one suggestion, though. If you want to buy volatility, buy it where it's actually happening. It's better to pay up for short-term IWM volatility than bet on it spreading to SPY.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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