Bad Markets Cause Volatility, Not Vice Versa

Today, I wanted to talk about the stock market’s volatility which has received a lot of attention recently. Many investors misunderstand the character of volatility. The key fact to understand is that volatility is not a factor separate and apart from the market’s recent direction. Markets do not go down due to volatility. Rather, bad markets are the primary cause of volatility.

As I’ve explained before, movements in the stock market are generally not symmetrical. Bull markets tend to be long and slow while bear markets are short and quick. Even in secular bear markets, most of the pain is confined within a short period of time.

The single-best days of the market almost always come after the single-worst days. These spikes aren’t really bullish moves so much as they’re counter rallies in rough markets. In fact, when the market is at a new high, the daily movements are far more subdued than they are normally.

You’ll often see the VIX quoted which is the Volatility Index. For newer investors, let me explain what the VIX is. In the formula to calculate options prices, one of the variables is volatility. As a result, we can take the current options price and work backward to find the implied price of volatility. And just like everything else, volatility can be bought and sold.

Warning: Math Ahead

The VIX shows the one-month standard deviation for the S&P 500, but the number is annualized (don’t ask me why). To get that number to a monthly figure, just divide the VIX by 3.464. That’s the square root of 12. Fans of math will remember that the standard deviation rises by N^0.5.

The VIX closed yesterday at 28.43. That means traders see the S&P 500’s one standard deviation over the next month as being 8.2%.

For some context, the stock market has historically gained about 1/30 of 1% each trading day. The daily standard deviation is about 1%. That means that about 97% of each daily move is, on average, complete noise.

After one month, assuming 21 trading days, the market averages a gain of 0.7% with a plus/minus of about 5.5%. After a year, the market averages 8.4% with a standard deviation of 16%. Even after four years, the market’s average gain and standard deviation are equal at about 33%. In other words, it’s perfectly reasonable for the stock market to be in the red even after four years.

Of course, these numbers are merely explanatory. The market doesn’t move according to the bell curve, which furthers my point about volatility.

I took the last 25 years’ worth of data on the S&P 500 and VIX. I then compared the VIX to the S&P 500’s position versus its 52-week high. The relationship is very strong. The further below the 52-week high, the higher the VIX.

Here’s what my chart below means. When the market is at its 52-week high, the average VIX is 15.16. When it’s 0% to 1% below its 52-week high, the VIX averages 14.92. The bigger the fall, the higher the VIX.

From 52-Week High Count Average VIX
Zero 657 15.16
0 1 1192 14.92
1 2 923 16.02
2 3 661 17.12
3 4 507 18.35
4 5 385 18.97
5 7 464 20.56
7 10 331 24.24
10 15 414 26.48
15 20 346 25.67
20 25 258 27.42
25 30 110 32.85
30 40 120 39.30
Over 40 99 50.55

I would guess that the relationship is even stronger if you use a time period shorter than 52 weeks. I wouldn’t be surprised if three months is more accurate, or even one month.

Think of it this way (in VERY rough terms): the VIX should be around 14 to 15 in placid times. It will increase by 1 point for every 1% the S&P 500 is below its 52-week high.

Posted by on September 1st, 2015 at 12:22 pm

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.