Monday, October 23, 2006

When VIX Is Low, Will The Next Day Be Slow?

My most recent post to the Trading Psychology Weblog observed that the weekly high-low range following a week that ends with a low VIX is about 1/3 narrower on average than the normal weekly range. In honor of last week's closing VIX of under 11, let's drill down and see if low option volatility at the end of one day is associated with low stock volatility the next day.

I went back to 2004 (N = 706 trading days) and found that the average daily high-low range for the S&P 500 Index (SPY) was .94%. When the daily closing VIX was above 16 (N = 125), the average daily range was 1.17%. When the VIX was below 12 (N = 169), the average closing range was only .77%. That tells us that average next day price volatility is about 30% lower following a relatively low VIX day than a relatively high day.

Overall, the relationship between daily closing VIX and next day equity price volatility was linear:

VIX over 16: Average Range: 1.17% (N = 125)
VIX 14-16: Average Range: 1.02% (N = 183)
VIX 12-14: Average Range: .87% (N = 229)
VIX under 12: Average Range: .77% (N = 169)

To put this into practical perspective, consider that, when the VIX closed below 11 (N = 28), only 4 of the next 28 days had a range exceeding 1%. When VIX closed at or above 18, however, (N = 40), 29 of the next 40 days had a range exceeding 1%.

High-low volatility is an important component of opportunity for the day trader. By knowing how much movement is likely in a day, we can gauge how much we're likely to take out of trades lasting a given duration.

Recall also that volatility is very closely correlated with volume and the presence of large traders in the marketplace. The relationship between VIX and equity price volatility is telling you something very important about the dynamics of participation among large traders. When relatively little premium is priced into options, no one is expecting dramatic movement--and in the short run, their expectations are self-fulfilling prophecies.