Thumbs up to Bill Luby at VIX and More for his post Implied Volatility and Magnitude vs Direction. Bill explains why, despite the fact that the VIX should only be measuring expected market volatility, it is very highly tied to the direction of the market (moves up in the market tend to bring the VIX down and vice-versa).
Bill’s argument is in a nutshell that the market is often guilty of panic selling, but rarely guilty of panic buying. This asymmetry means that market declines do more to increase investor expectations of future volatility and what lurks behind the next corner. He concludes:
Ultimately, the same aspects of investor psychology and behavioral finance (i.e., loss aversion) that translate into more panic selling than panic buying also mean that the supply and demand imbalance for options is typically greater in sharp bear moves than in sharp bull moves. The result is that implied volatility tends to spike more with an X% drop than as a result of an X% rise. Statistically, these moves are identical, but psychologically and from a transaction perspective, spikes down will generally move implied volatility more than comparably sized spikes up. Since the VIX is essentially the implied volatility of the SPX, this is one of the reasons why the magnitude and direction of a market move determine the impact the move will have on the VIX
Put another way, Bill shows in words why we observed the high negative correlation between changes in the VIX and the S&P 500 in our post The VIX isn’t Magical.
Happy Trading,
ms
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