Rising from the ashes – the VIX in 2020

Until recently, the market has been ignoring any exogenous risk factors with benign neglect. Take a pick of your favorite crisis from the atrocities in Syria, Brexit, the refuge crisis & European disintegration, North Korea or the trade war with China – equity markets shrugged off all of the above. As recently as the 2020 Economic Summit in Davos, we have heard pronouncements of “the end of the boom-bust cycle as we know it” or statements such as “cash is trash.”

Fear has replaced the complacency of the past few years, and with that, all eyes are now focusing on a long-forgotten friend, the VIX a.k.a. the “Fear Index.”  Google Trends suggest that the VIX has been rising from the ashes. The search term “VIX” was at an all-time high in March of this year.

To get a better perspective, I thought a brief primer on the VIX along with a trip through history might be in order. 

The original VIX was created by Robert Whaley, who devised a method to extract the implied volatility from options on the S&P 500 Index. In essence, he suggested to use market prices of these options as a given and solve for the only unknown from the Black-Scholes-Merton model, i.e. implied volatility. In 2003, the Chicago Board Options Exchange (CBOE), together with Goldman Sachs, changed the methodology, which is more akin to a Variance Swap and no longer based on the Black-Scholes-Merton model. For those of you who are interested, you can find the exact VIX methodology here.

Although the VIX has only been averaging around 20 since its creation, we have seen intermittent spikes occurring ever so often. The chart below, contrasting the VIX with the S&P 500 also shows that there is a negative correlation between the two indices.

Adding some statistical measures, we can see that there have been periods of low or high volatility that affect the overall sentiment of the market for the entire year. While the long-term average of the VIX is just under 20, we had protracted periods of much lower and much higher than average volatility. The obvious comparison to make is of course the current market turmoil and the last crisis of 2008.

We should also point out that there have been some remarkable periods of low volatility. 1995 and 2017 stand out as periods of extremely low volatility. Interesting to note here, 32 of the forty lowest ever VIX levels occurred in 2017. The same year showed 6 of the ten lowest VIX levels ever recorded.

We can also get a sense of volatility by the decades. The average VIX in the 90’s was 19.24, climbed up to 22.12 in the 2000’s and reverted back to 17.17 in the past decade. 

Now that we have a picture of the price of volatility over time, we should also find out what the value of volatility implies. The VIX is an estimate of future volatility 30 days out, but it may be more useful to know what that means in translation. A VIX of say 20 corresponds to an expected 20% annualized standard deviation of returns. In essence, we should expect that the market could go up or down by about 20% per year. Volatility, however, is a different “beast” compared to traditional assets. It does not scale linearly with time. Instead, it scales with the square root of time.  A VIX of 20 then translates to an implied daily S&P change of 20 ÷ √252 or 1.26% (assuming 252 business days per year). 

From a volatility perspective, the past decade clearly lulled us into a sense of complacency. We could almost hear echoes of past voices. Those who remember the phrase “housing prices never go down” may also have heard that “risk had been conquered” around the same time. What led to this recent decade of complacency is too complex to include in this article but take a look at how market dynamics changed from active to passive investing, incessant growth of ETFs, Robo-advisors, algo-funds etc. to give you an idea.

The reason why so many market practitioners have been caught off-guard in the recent turmoil is probably a function of our behavioral tendency to compare current conditions with past episodes, regardless of how appropriate they may be from a statistical perspective.  We assume these conditions to be the norm and find ourselves in a quagmire when our assumptions no longer hold.

Many of us who experienced the last financial crisis have been watching the unraveling of the current crisis with a sense of déjà vu and cannot help but draw comparisons to 2008.  Given the pricey valuations of many companies, forecasters warned that a repeat of the phenomenal returns of 2019 may not be possible. Still, the extent of the downturn has surprised almost everyone. It wasn’t just that we were surprised by the 30+ percent decline in the major market indices, but it was the velocity and voracity of the decline that shook us.

This year, it took the VIX only 51 days to get to the same level it did in 2008 when the index needed 208 days to reach a level of about 80. The tremendous speed in the increase of volatility is what left many of us nauseous.

What’s next then, you might ask? That is the multi-million dollar question everyone is trying to grasp.

Assuming the VIX is a correct forecast of future volatility in 30 days, we can expect choppy waters for a while longer. The VIX closed at 53.49 today. When we do the math, it suggests that we can expect a daily price change in the S&P of about 3.4%, which translates to an expected price change of about +/-15% over the next month (20 business days). Make no mistake though. It does not suggest that the move can be to the downside only. Either way, fasten your seat-belts!