There are some that believe that the VIX can predict future price volatility in the market. Mean Reversion is one thing, but the believers in the predictive nature of the VIX claim more. The head of our research team, Michael Rechenthin, Ph.D., aka Dr. Data, joined the guys to check this out. Mike mentioned that this is a topic covered in Shelly Natenberg’s book “Option Volatility & Pricing”. What exactly did Dr. Data find out?
Mike began by displaying a graph charting both the VIX and the SPX (S&P 500 Index). He also displayed a scatter plot chart of the daily change in the VIX versus the daily change in the SPX. The strong inverse correlation between the two can be seen and it was noted on the scatter plot that the negative correlation was -0.71. Mike mentioned that the VIX tends to move 4 times as much as a percentage change in the S&P 500. So we know about the high negative correlation, but if the VIX is predictive of future volatility when the VIX increases, we would expect to see the future market action more volatile than the past.
Dr. Data proved that there is nothing behind the claims of VIX’s predictive abilities. He produced another scatter plot graph which plotted the change in volatility (forward volatility minus historical volatility) versus the daily change in the VIX and showed no predictability. Another chart displayed the difference between Implied Volatility and Actual Volatility over a 10 year period. Mike explained how this demonstrated Implied Volatility overstates actual volatility and how persistent fear after large moves can cause an overestimation of volatility. Tracking the VIX will give you an edge in selling premium because Implied Volatility (IV) is mean reverting but it doesn’t predict the level of future volatility in the markets.
Watch this segment of Skinny on Options Data Science with Tom Sosnoff, Tony Battista and Dr. Data, aka Michael Rechenthin, Ph.D., for a fascinating look into the the age old question; does the VIX have the ability to predict future market volatility?
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