Note on the VIX, courtesy of Condor Options.
Is the VIX Getting Complacent?
The market indexes closed down over 2% today [the 18th], which in the context of late 2008 trading is barely worth noticing. But the conventional wisdom says that implied volatility and equity prices move inversely, and the VIX is also down on the day, by about 5%. So which measurement is “wrong”? Have implied volatility expectations drifted too low? Is the VIX getting complacent?
Executive summary: no.
Since the middle of 2007, there seems to have been a small tradable edge in getting short the market when both SPX and VIX close down on the day (profit factor of 1.98 over the past two years). The intuitive explanation might involve something about traders underestimating downside followthrough. As we all know, however, intuitions can be fantastically wrong.
The attached chart displays the performance since 2004 of a strategy that shorts SPX on the close when the index is down from the previous closing price and VIX is also down on the day. All trades are closed out two days later. The first thing to notice is that the conventional wisdom may be right over the medium to long term, but on a day-to-day basis, it’s actually quite common to see the S&P 500 and the VIX both close down – about 25 times a year, to be precise. Secondly, notice how the equity curve of this system mirrors the inverse of the index itself. That suggests that the performance of this “complacent VIX” system has more to do with the broad market trend than with any special signifiance of the VIX and SPX both closing in the red.
This confirms some of Bill Luby’s recent discussion regarding the 2×2 matrix of SPX-VIX daily outcomes; if there is sufficient reader interest, we’ll test the other three quadrants and post results.
Photo courtesy of Flickr user dcassaa.
