As the equity markets rally from the March 24th bottom gains steam, the VIX volatility index has more than halved since its all-time high on March 16th. VIX hit the 80 level for the first time during the financial crisis. Unlike a decade ago, it only took a month for the VIX to drop below 40 from the peak. Not only was the absolute level of VIX in March unprecedented, but also the velocity of VIX change was unparalleled in the history of the index. Even though the equity market has rebounded over 30% since the March low, a 30-handle VIX is likely to stay as long as the large daily swings remain.
Usually, when we discuss the VIX, we refer to the 1-month volatility index provided by CBOE. However, there are multiple VIXs: 9-day, 1-month, 3-month, and 6-month VIXs are all available on CBOE’s website. Not surprisingly, all of the indices made all-time highs in March. Particularly, the 9-day VIX topped the 100 level for the first time. The 1-month VIX is the most commonly used one because it was launched much earlier than the others. We have written about the 1-month VIX becoming a victim of Goodhart’s law in the past (https://www.cumber.com/goodharts-law/). What about the other VIX indices? We will explore them today, comparing each to its corresponding realized volatility.
As Chart 1 shows, the 1-month VIX is highly correlated with realized volatility, indicating it is a contemporaneous index; but there is not much evidence supporting the 1-month VIX as a leading indicator for forward volatility.
Short-term price tends to include noise from investor sentiment, which can be why the short-term VIXs are mimicking realized volatilities so closely. What about the long-term ones? Interestingly, the 3-month and 6-month VIXs have not been subject to the Goodhart’s law yet. As Charts 3 and 4 reveal, the longer the VIX term, the more pronounced its indicating power. Nevertheless, we would like to caution investors that this may not be a leading indicator for a long-term VIX trading strategy, because the lag in realized volatility is likely caused by the prior short-term volatility. In other words, it takes more time for the long-term realized volatility to rise (or fall) than it does for the short-term.
Last but not least, the correlation between the volatility index and the realized volatility is the highest for the 3-month VIX, roughly 90.82%. If we want to tick out as much noise as possible when it comes to VIX, maybe we should look at the 3-month term instead of the popular 1-month term.
Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
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