Take VIX, the popular measure of volatility implied by options pricing, as an example. We might make inferences about whether stocks will go up or down based upon VIX being stretched to the upside or downside. What we know, however, is that VIX tends to move inversely with index price. VIX also tends to move up or down with realized volatility. So when we look at a display of VIX, are we truly seeing a reading of options-implied volatility or are we seeing a conglomeration of several correlated variables?
To illustrate the point, I built a simple model of VIX that eliminates the overlapping influence of previous price movement and recent realized volatility. This adjusted VIX measure captures the degree to which implied volatility is high or low relative to what we would expect based upon previous price movement and realized volatility. A high adjusted VIX means that options are pricing in more volatility than we would normally expect from the recent price movement; a low adjusted VIX means that options are pricing in less volatility that we would normally expect.
I went back to 2012 and divided the adjusted VIX into quartiles. When the adjusted VIX was in its strongest quartile, the next five days in SPY averaged a gain of +.49%. When the adjusted VIX was in its weakest quartile, the next five days in SPY averaged a gain of +.72%. When the adjusted VIX was in its middle two quartiles (i.e., when VIX was pretty much in line with what we'd expect from recent price action), the next five days in SPY averaged a loss of -.01%.
In other words, all the market's gains since 2012 can be attributed to "mispricing" of VIX. But you would never see that in a simple chart of VIX.
Trading by sight does not always bring vision.
For those interested, the adjusted VIX is currently in its lowest quartile, understating the price movement we've seen recently.
Further Reading: Pure Volatility
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