The VIX isn’t Magical
I am about 72% in agreement with a recent post from Mark Hulbert and follow up posts from (among others) the Daily Options Report and VIX and More. The VIX isn’t as magical as it might look at first glance. The reason is that so much of the VIX is comprised of information we already know.
If you are unfamiliar with the VIX, I would suggest reading this very good VIX primer.
Last year, I put a couple of weeks of intense analysis into the idea of deconstructing the VIX into its constituent parts to understand how it could be used as a timing indicator. For the life of me, I can’t seem to find that data, but the general idea went something like this…
For the most part, the absolute VIX level is a function of recent market volatility (not necessarily future volatility). As depicted in the graph above, there is an 84% correlation between the previous 20-day standard deviation (volatility) of S&P 500 returns and the absolute level of the VIX. Linear reg. equation for the chart above: Estimated Absolute Value (EAV) = 1244.0x + 7.7
To a lesser degree, day-to-day changes on the VIX are a function of day-to-day changes on the S&P 500. As depicted in the second graph, there is a -69% correlation between (lognormal) changes in the two. Linear reg. equation for the chart above: Estimated Price Change % (EPC) = -4.0x
Putting these two factors into a very SWAG’ish formula for predicting the VIX we get something like Estimated VIX = EAV + (EAV * EPC).
A graph of these estimated versus actual VIX values looks very tight:
That’s an 85% correlation (r-squared = 72%, hence why I’m 72% in agreement). By comparison, that’s about the same level of predictive ability the S&P 500 has in determining the value of the Nasdaq 100 (and that’s pretty darn high).
A more rigorous analysis could definitely do a better job at coming up with a formula for predicting the VIX, but I just want to prove a point: the vast majority of what the VIX is telling us, we already know (changes in price and volatility).
But as I mentioned in the opening to this post, I disagree a slight bit with some previous posters. In the past, no matter how much I have tried to decompose the VIX into its building blocks, there was always an element of trader-driven unpredictability. I haven’t figured out how just yet, but I think that if we can isolate what that smaller subset of information is telling us, we might have something useful and unique.
Filed under: VIX & Volatility | 2 Comments