Why No One Ever Forecasts Lower Volatility

The market perpetually prices in a CBOE Volatility Index (VIX) lift

Nov 19, 2014 at 9:04 AM
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So I saw this rhetorical question go by on Twitter yesterday morning: "Has anyone ever forecast 'less volatility'?"

Generally speaking, the answer is a resounding "no." Anecdotally, nearly any time the topic comes up on TV, it's always in the context of what could cause some sort of future market unrest. No one ever predicts the current calm will persist. Granted, that would make for lousy TV. I imagine if you were asked to make a prediction and you said the same boring, grinding, very-low-volatility upward climb continues, with perhaps two to four randomly spaced shakeouts in the next year, and you had no idea what might cause those shakeouts, you wouldn't get asked back. But saying "the present trend continues" is always a good guess. Trends persist; major changes in tone and direction are relatively rare.

As to predicting volatility itself, you really need specifics. Ten-day realized volatility (RV) in the S&P 500 Index (SPX) sits under 4 now. That translates to a 0.25% range on a typical day. That's about rock-bottom volatility for that particular metric, so no one expects less volatility there.

The price of every option everywhere embeds a volatility forecast for the time period between "now" and when the option expires. So, we don't even need humans to verbalize their volatility forecasts, because money talks. We can quantify those volatility forecasts (i.e., the implied volatility) and compare it to backward-looking realized volatility and give an objective answer to the above question.

And, as we note often, options virtually always price in an uptick in current volatility. The CBOE Volatility Index (VIX) averages about a 4-point premium to RV. The only time RV tends to exceed implied volatility is when you get a pop like we saw in October. And even then, it was more just about the time lag. VIX peaked at 30 on Oct. 15, while the realized volatility calculation peaked on Oct. 21 at 22.5 -- by which time VIX had dropped into the high teens.

What's more, VIX futures almost always predict that VIX itself will lift going forward. January VIX is about 18 now. Unless VIX itself has already popped, this song always remains the same.

So if someone ever asks you whether you think volatility will rise or fall in the future, you should probably just say "Well, the market prices in a volatility lift, so if you believe that's wrong, just sell options and VIX futures."

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


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