What to Make of the Volatility Lull

Historical volatility over the past five days has been nearly nonexistent

by Adam Warner

Published on Dec 31, 2014 at 7:55 AM
Updated on Apr 20, 2015 at 5:32 PM

I forgot to write down one of my predictions yesterday. So here we go: I bet realized volatility (RV) lifts in 2015, at least from these levels.

A 16 volatility equals about a 1% move on a typical day. So, 2.6 volatility means something like a move of 0.15% or less on two-thirds of days. In other words, about 3 S&P 500 Index (SPX) points. Ouch. Now, in all fairness, it was a holiday week that included a half session and a low-volume "island" Friday that coincided with Boxing Day, and we know that no one trades on Boxing Day while returning presents and watching English soccer.

So let's say that "real" RV is twice that high. Heck, let's say it's three times that high. Call it 8 volatility. The CBOE Volatility Index (VIX) itself is 16. That's twice the level of an adjusted RV guess. Yes, they are two different animals. RV looks backward, implied volatility prices on forward expectations. There's no arb, and there's theoretically no relationship. Except, in reality, there is a relationship. VIX does a better job predicting what already happened than what happens next.

In my book, I ran numbers to compare how well VIX correlated to backward-looking realized volatility, and other numbers comparing how well VIX correlated to ultimately simultaneous volatility. For the latter part, that would involve taking today's VIX (16) and then comparing it to realized volatility over the next 30 calendar days. Obviously, we can only do that in hindsight.

Long story short, VIX from inception to about 2008 (when I wrote my book) had about a 0.85 correlation to backward-looking RV (both 25-day and 30-day, for what it's worth). Simultaneous VIX had a 0.74 correlation to RV. That's still strong, but not quite as strong.

That's a longer-winded way of saying it's possible VIX is accurately predicting an uptick in volatility, but the more noteworthy takeaway is that it's unusually overpriced vs. the RV we can see on our screens right now. So, news flash: the market expects an uptick in volatility. Unscientifically, I'd say VIX has called 40 of the last six RV spikes. But you never know.

What I do know is that's a wrap for 2014. Have a great New Year's Eve and a happy and healthy New Year's, and let's go get them in 2015!

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

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