I’ve spent a great of time looking at and studying the volatility market. By no means am I the most knowledgeable on the topic, I’m not that naive. But I’ve been fortunate enough to have my research on the volatility index recognized by the CMT Association, having been awarded the Charles H. Dow Award in 2017 for my paper, Forecasting a Volatility Tsunami. The paper (and this post) was/is not intended to be an all-encompassing trading signal for the VIX, but rather to outline a unique development in the volatility market that’s often led to spikes in the underlying ‘fear index.’
While I’d strongly encourage you to read the paper in its entirety (don’t worry it’s not that long, the math isn’t complicated, and there’s some great charts!), the main point I drive home with what I wrote was that historically the dispersion of daily activity for the spot $VIX Index becomes extremely low before a spike has occurred. The wording here is important. We’ve had several occurrences of dispersion, as measured by standard deviation, hit a low threshold that have not been accompanied by a large move higher in volatility. However, it’s been quite rare for the VIX to spike higher without first seeing dispersion drop.
Put another way…
For most parts of the world, it rains. It doesn’t rain all the time but thankfully there are signs that often precede big rain storms. One of those signs is the darkening of the clouds. You don’t want to always be wearing a raincoat or carrying an umbrella, but if you were to see the clouds begin form and darken, you may think it wise to grab that coat and umbrella as a precaution. It’s rare to have a thunderstorm (not impossible) without first having a darkening of the clouds but it’s also possible for the clouds to darken without producing a storm.
Just like the darkening of clouds, a narrowing of dispersion in the VIX often occurs before it materially moves higher. But a move higher does not always occur with standard deviation drops, requiring further analysis to better understand the developments within the volatility market.
Below is a daily chart of the VIX and the 20-day standard deviation with a blue line at 0.86 (the level I discuss and explain within my paper.) As you can see, std dev often declines substantially before nearly every major spike in volatility. This acts as a much better forecast of volatility spikes than other more popular techniques (again, something I cover in my paper).
I bring this up today, because for the first time in several months, dispersion in the VIX has declined quite a bit, i.e. dark clouds have begun to form over the market. Does this mean the VIX will spike higher? Maybe. Maybe not.
As I said, many declines in dispersion are not followed by volatility spikes. This is why other types of analysis and data must be evaluated, which is exactly what I do with my Volatility Risk Trigger (VRT), something I share with subscribers of Thrasher Analytics.
When was the last time VIX dispersion got this low? From mid-December ’17 through mid-January ’18, which set us up for one of the largest volatility ‘thunderstorms’ that the market has experienced.
Volatility is a topic I cover in great depth with those that subscribe to Thrasher Analytics. If you’d like to learn more, click here.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.
