Woodard: Two VIX Based Signals of Market Risk
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Everyone watches the CBOE Volatility Index (VIX) as a measure of expected risk and market sentiment. I've argued before that many of the ways traders try to make sense of VIX don't work ("How to Perform Technical Analysis on the VIX"), but here are two more valuable methods. We can use these two tests to see whether recent market weakness is reason enough for investors to hedge their portfolios.
1. The momentum of volatility
Fig. 1 shows a daily chart of VIX along with two short-term moving averages. This is a deceptively simple, but effective chart because it captures one of the most important aspects of volatility: in the short term and during market sell-offs, volatility exhibits momentum effects. Over the long term, volatility is mean-reverting, and that makes short-volatility strategies and positions profitable (look at XIV). But during those periods where you want to hedge, the opposite behavior holds - the more volatile the market is today, the more volatile it is likely to be tomorrow.
A signal based on moving averages can serve as an effective "first responder" to warn of changes in the market climate. Right now, this signal is indicating a "risk off" environment. We won't be adding new long stock positions at this time, and will begin reducing long exposure if the signal strengthens. The momentum of volatility is a key input in the VXH hedging strategy that we publish.
2. The realized volatility of volatility
Another feature of risky market environments is that they exhibit high volatility of volatility: no matter what the absolute level of VIX might be, in the past the riskiest periods have coincided with a VIX that deviates from its local mean more widely than normal. To quantify this estimate, we can look at the standard deviation of daily VIX changes relative to the distribution of those changes in the recent past. At higher quantiles, short-term VIX standard deviation indicates that the market is becoming collectively more uncertain about the future. Right now, the realized volatility of volatility is not even close to flashing a warning signal: it is below the median value of the distribution over both the prior quarter and the last year. We would not want to scale aggressively into hedge positions until this signal changes.
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