Was Last Week's VIX Spike Warranted?

Exploring whether or not a spike in the VIX can lead to a bullish stock move in the future

Senior Quantitative Analyst
May 19, 2021 at 8:00 AM
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Last Wednesday, the S&P 500 Index (SPX) fell over 2% after closing near an all-time high the day before. The Cboe Volatility Index (VIX), which measures implied volatilities on SPX options and is often considered a fear gauge for the markets, jumped over 25% on that move. It was touted as a significant move for the VIX, but it made me curious as to the kind of reaction you would expect from the VIX in such circumstances.

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In Line with Expectations

This scatter plot gives us an idea about what kind of move we would expect, given the circumstances of last Wednesday. Specifically, I looked at times since the financial crisis that the SPX was within 2% of an all-time high with the VIX around 20 (+/- 5 points). Then, I simply plotted the VIX returns vs. the SPX returns. The green trend line shows what you might expect given a move by the SPX. That circled red dot is the plot from last Wednesday. You can see it is not too far above that green line. Additionally, when you get over 2%, the VIX tends to move higher than the trendline suggests. I would conclude the VIX’s move on that day was expected given the circumstances.

The red dots in the plot are the more recent readings. There doesn’t seem to be a bias one way or the other relative to the green trendline. It suggests there’s nothing out of the ordinary as far as how the VIX is reacting to market moves at the moment.

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VIX Reactions as an Indicator

Doing the analysis above got me to consider whether there might be an indicator in these VIX reactions. My theory would be that when the VIX spikes bigger than expected, given the circumstances, it indicates fear in the market. The contrarian take would be the VIX spike would lead to bullish stock returns going forward.

To determine if this is a viable indicator, I looked at those same returns as the analysis above. Recall, those are instances when the VIX is between 15 and 25 and the SPX is within 2% of an all-time high. The expectations of the VIX reaction would change based on the market environment. Then I measured how far away the VIX return was from what one would expect (the distance between the dot and the green line in the chart above). The first table below shows how the SPX did going forward, when the VIX reaction was well above the expectation. The second table shows SPX returns after the VIX reaction was much lower than expected.

Admittedly, since the VIX is a measure of the expected volatility over the next 30 days, I was looking at this to be a shorter-term indicator. In the short term (two-week and one-month returns), the SPX underperformed when the VIX had bigger spikes than expected. This is the opposite as what my theory was. The indicator, however, performs much better in the longer term. Looking at the six-month returns, when the VIX spikes are a lot higher than expected, the SPX gained an average of almost 9% with an impressive 96% of the returns positive. When the VIX reaction is lower than expected, the index gains an average of 3.3% with 75% of the returns positive. Perhaps the jumpiness in the options markets is a better longer-term indicator

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If there’s a viable indicator here to add to the arsenal, it will take a lot more studying. The fact that the bullish returns take so much time to materialize (the returns are bearish out one month), give me pause to consider it for now. For the sake of completeness, the table below shows how the SPX performed after the VIX reaction was in line with expectations.

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