Traders Misjudge Volatility Following Big Moves in the VIX

The volatility of stock returns decreases with time. Big short-term upward and downward moves get smoothed out, reducing the fluctuations of returns. This is why it is advantageous to look at your portfolio infrequently.

Looking too often does more than just potentially fraying your nerves. It also alters your perception. When you pay attention to what the market is doing on daily basis, the odds of you misjudging how volatile stocks are increases. A study in the current issue of the Financial Analysts Journal demonstrated this using distortions in the CBOE Volatility Index (aka, the VIX).

“After prolonged exposure to high (low) realized volatility, perceived volatility is lower (higher) than actual realized volatility,” observed the study’s authors. “Future realized volatility is higher than implied by VIX … following volatility regimes in which volatility switches from extremely high levels to moderate levels, and vice versa.”

Very high levels are those that are more than one standard deviation above the rolling three-month (63 business days) average. Very low levels are those that are more than one standard deviation below average. The larger the difference between the VIX and its average, the larger the distortion in perceived volatility levels when the VIX moves back into its average range.

A simplified version of the trading strategy proposed in the study would be to shift from stocks to cash when volatility is at a very high level (with a bigger advantage to doing so when the VIX is at least 1.50 standard deviations above its average, and particularly at least 1.75 standard deviations higher). Elise Payzan-LeNestour, a Scientia Associate Professor at the University of New South Wales and one of the study’s authors, told me in an email that “most of [the strategy’s outperformance] comes from missing large drawdowns.”

While I am not a fan of market-timing strategies—because they add both timing and behavioral risks—it is possible to “sin a little” by paying attention to the VIX. If you were to calculate the averages and standard deviations (with a spreadsheet and widely available VIX quote data), you could use the level of the VIX to determine if it might be worth waiting a few days to invest new savings contributions or postpone taking withdrawals.

Such a strategy is in the same ballpark of what contributing editor Brian Haughey suggested in this month’s AAII Journal. His strategy called for looking for a move by the VIX above its five-day moving average. Such a breakout implies a potential decrease in volatility and higher returns for the S&P 500 index going forward. Investors seeking to invest new savings contributions or take withdrawals during periods of heightened volatility could wait for the VIX to rise above its five-day moving average before taking action.

The key with “sinning a little” is to have set parameters to ensure you don’t go from a little sinning to a lot of sinning. Just like having an occasional tasty dessert won’t wreck your diet, having one every day very well could. One rule would be to use a timing indicator for day X through day Y. On day Y, you invest the contribution or take the withdrawal no matter what the indicator suggests if you haven’t already acted. This rule can also work when you are simply trying to determine when to put cash to work, take a withdrawal or adjust your allocation. Keep in mind that it only works if you act by Day Y and do not look for additional reasons to delay acting.

Of course, the alternative—investing new savings or taking withdrawals on pre-specified dates regardless of where the VIX (or any other market-timing metric) stands—is often the best strategy. Doing so avoids second-guessing, incorrect forecasts and many other behavioral errors.