Sunday, April 19, 2009

VIX and Average Daily Volatility in the Stock Market

I recently emphasized the importance of tracking shifts in volume and volatility within and across markets, as these help determine the amount of movement traders are likely to experience. In this post, we look at volatility in the stock market (daily trading range, SPY) as a function of option premiums (VIX).

I went back to 1990 and broke the market down into six VIX categories:

Group One: VIX < 15 (N = 1501)
Group Two: VIX = 15 - 19.99 (N = 1315)

Group Three: VIX = 20 - 24.99 (N = 1091)
Group Four: VIX = 25 - 29.99 (N = 507)
Group Five: VIX = 30 - 39.99 (N = 288)
Group Six: VIX > 40 (N = 154)

What we see is that the average daily range is closely related to VIX levels, such that we see about three times the volatility in Group Four as in Group One. Note the sharp difference between groups Five and Six, which illustrates how extreme the recent markets have been--and how much volatility has dropped off as we've moved from a VIX approaching 80 to one below 35.

(Also note the N size associated with each VIX group. It shows us how historically unusual the recent markets have been).

I would argue that, by knowing the current VIX level and whether volume for the current day is running above or below average, we can make very reasonable estimates of the likely volatility for the unfolding trading day. This has real implications for how much we can expect to take out of trades, where we should place stops, and how we should size positions for prudent risk taking.