Volatility Spike: What Comes Next?

Friday's weak market raised the VIX, the measure of implied option volatility on the S&P 500 Index, by 8.79%. I went back all the way to January, 1990 (N = 4099 trading days) to see what happens after such a one-day volatility spike. Looking at the Dow Jones Industrial Average, I found an interesting pattern. For the group of volatility spike days (N = 329), the first hour of trading on the next day tended to be down and that next day tended to underperform the sample average. By three days out, however, there was no underperformance. Interestingly, however, since 2003 (N = 48) the first hour of trade after the volatility spike day has been up in price (29 up, 19 down), but the day overall has underperformed (-.04% vs. .04% for the sample overall). Three days out, this underperformance has largely disappeared--although I'm not seeing the three-day outperformance with the Dow that I noticed earlier in the S&P. It may well be that, after a very broad decline, it is the very broad market (not the large caps) that snaps back the most.

Finally, a reader asked about Fridays in particular. As the reader suspected, when the volatility spike day occurs on Friday, Monday has tended to be much weaker in the first hour, but largely recovers by the end of the day. This pattern has not been especially strong since 2003.

In general, broad weakness is associated with underperformance in the very short run, but reversal thereafter. This trade concept will frame my expectations for the start of the week, as I'll outline in tonight's Weblog.

ADDENDUM: I notice that, when you break the sample of volatility spike days down by the resulting VIX level, the three day outcomes for low VIX occasions (such as at present) are actually bearish. When the VIX after the spike is less than 15, the next three days in the Dow average a loss of -.17% (26 up, 31 down)--much less than the average gain of .12% (2260 up, 1849 down) for the sample overall. The results are even more bearish when we just look at the findings since 2003 (N = 22). Three days later, the Dow is down by an average .40% (8 up, 14 down). For me, such findings are a heads-up, warning of the dangers of being too complacent in bottom fishing. Such heads-up findings proved hugely profitable last October, when weakness led to further weakness for quite a few days.