What Volatility Really Means
Allianz Global Investors
By Greg Tournant
July 28, 2015
Which ‘Volatility’?
Stock-market volatility has been widely predicted to increase in 2015, with the US Federal Reserve (Fed)-fueled bull market now in its sixth year. But what is meant by "volatility"? In the context of market forecasting, it typically means one of three things:
- Implied volatility. This signifies how much the options market expects equities to decline. The best known gauge, the Chicago Board Options Exchange Market Volatility Index (VIX), measures implied volatility of at-the-money S&P 500 put and call options over the next 30 days. In the first half of 2015, the average implied volatility level was 15, low by historical standards.
- Realized volatility. The realized volatility of the S&P 500 measures how much the index fluctuates daily. Investors often associate high realized volatility with a turbulent market, but this is not necessarily the case. For example, if the index alternates moving up and down 2% every day but never goes anywhere, realized volatility will look misleadingly high.
- Index path. Conversely, a market that trends slowly but persistently downward can be a painful environment for equity investors, yet can still exhibit low realized volatility because of the gradual nature of the decline. Despite the widespread discussions about “volatility” in one form or another, the index path is actually what investors tend to care about the most.
High or Low?
Since its introduction in 1985, the VIX has averaged approximately 19, and has ranged between 9 and 90. To many, the VIX—having hovered in the low- to mid-teens for most of the past 3.5 years—seems poised to increase toward its historical average. We disagree.
The VIX isn't necessarily mean-reverting. Because data on the options market date back only 30 years, there is a common tendency to ignore the decades of prior market history. But looking over much longer periods, as we do, reveals that the VIX can remain low for protracted periods. Even during the 1950s and 1960s—periods with plenty of uncertainty and upheaval—realized market volatility was low. Based on a synthetic VIX that we created using historical realized volatility data, during these two decades the VIX would have averaged just 14, and would have remained below a 20 level 92% of the time.
Predicting the direction of the VIX is notoriously difficult, and we certainly have no idea where it is going. But one thing we do know is that the VIX can remain low for longer than the long-volatility investor can remain solvent.
News Fatigue
Sometimes bad news sends the VIX soaring, but at other times, equally bad news brings about a more subdued VIX response. The difference? News fatigue.
When an issue has been worried about long enough, it somehow becomes less worrisome. Greece, for example, has been in the news for several years. While its debt crisis remains as potentially damaging as ever, investors have become desensitized to the risks. Similarly, the possibility that the Fed might soon raise interest rates has already been debated for several months, such that by the time rates actually rise, there may be no reaction in volatility.
In contrast, recall October 2014, when markets were roiled by fears of an Ebola outbreak. The VIX shot up to 27, not only because of the seriousness of the issue but also because of its suddenness. The same was true two months later, when cratering oil prices caught markets off guard and sent the VIX to elevated levels for nearly six weeks.
What will cause the next volatility shock? We don't know, but we doubt it will be any of the issues that investors are currently worrying about. The VIX seems to react primarily to “new news.”
Greg Tournant is a portfolio manager, a managing director and CIO US Structured Products with Allianz Global Investors. He is also Head of the Structured Products team. Mr. Tournant has 19 years of investment-industry experience. He has a B.S. from Trinity University and an M.B.A. from the Kellogg School of Business at Northwestern University.
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The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility.
Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
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