Indicator of the Week: What Does the Low VIX Mean for Stocks?

Does a low CBOE Volatility Index (VIX) predict rising stocks or low volatility?

Senior Quantitative Analyst
Aug 10, 2016 at 6:37 AM
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The CBOE Volatility Index (VIX) has fallen to extremely low levels. The current level of the VIX is easily within the lowest decile of closing values going back to 1990 (as far back as we have data). For those who are not familiar with the VIX, it is calculated using option prices of S&P 500 Index (SPX) options, and it is a measure of the expected volatility of the S&P 500 over the next 30 days. A low VIX means SPX options are cheap, or that traders are expecting very little volatility in the next month. Since stocks tend to fall a lot faster than they rise, it can be implied that when traders expect low volatility, they expect rising stock prices. When the VIX is high, it means option traders expect a lot of volatility, and therefore falling stock prices. That’s why the VIX is often referred to as the "fear gauge." 

So the question becomes: what does the level of the VIX mean for stocks going forward? Does the low VIX, in fact, predict rising stocks or low volatility? The analysis below should give us some answers. 

Simple Decile Analysis: The VIX closed at 11.66 yesterday. Since 1990, the VIX has closed lower just 5.4% of the time. For the analysis below, I created deciles (10 brackets) of dates depending on the level of the VIX. Then I found the return of the SPX over the next 21 trading days (about 30 calendar days), and summarized the returns for each decile. 

This first chart shows the average S&P return over the next month, depending on the level of the VIX. The average return for the SPX when the VIX reading was in the lowest decile was 0.57%. That is the data point furthest to the left, where the x-axis says "Low VIX." That’s the bracket we are currently in. As you move to the right on the chart, each marker represents the next decile as the VIX level gets higher and higher.

If a high VIX is supposed to indicate pessimism by option traders, which I suggested above, then they have not been very good at predicting stock returns over the next month of trading. You can see that in first decile to the eighth decile (or when the VIX ranges from 9.31 to 24.53), the SPX average one-month return ranges from 0.23% to 0.75%. After that, it shoots higher to almost 1% in the ninth decile, and finally 1.73% in the last decile, when the VIX is highest. Ultimately, where we stand right now -- in the first decile -- there is not much actionable information we get from this chart.

                           SPX average 1 month return chart 1

Next, I looked at the percent positive of S&P returns over the next month, depending on which decile the VIX is in. The percent positive ranges from 58% (eighth decile) to 66% (tenth decile) with no trend moving from left to right in the table. Again, I don't get much useful information when looking at this.  

                               SPX 500 percent positive chart 2

Predicting Volatility: Is the VIX any good at predicting future volatility? It should be, since that’s exactly what it is supposed to do. It’s the 30-day implied volatility of the S&P 500 Index over the next 30 days, based on SPX option prices. As you can see below, a low VIX does, in fact, tend to lead to low volatility over the next month of trading. Where we're at right now, in the first decile, the standard deviation of the returns over the next month has been 2.2%. As the VIX gets higher and higher, the standard deviation of returns rises to a high of 7.5% in the tenth decile. 

                                SPX standard dev chart 3

Here's one last way to measure volatility. It's a chart showing the average positive return and the average negative return of the SPX over the next month of trading for each decile. In the first decile, you can see the average positive and negative is essentially +/-2%. That range gets wider and wider as the VIX increases until the average positive and negative is roughly +/-6%. 

                                   spx positive negative chart 4

To sum up everything above, the VIX is extremely low right now, and in the past this has typically been followed by very low stock volatility. However, it tells us next to nothing about stock performance. 

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