What are volatility indicators telling us now?
Markets are discounting mechanisms and volatility trends are a leading indicator. One of the best indicators for determining market bottoms is the market based pricing of current volatility relative to future volatility. All should know what the VIX indicator measures; often referred to as the fear and greed gauge. Volatility is the major factor in pricing risk or insurance into derivative prices. It’s a good indication of the magnitude of future price changes. The VIX measures the expected change in the puts and calls for the next 30 days of all the S&P 500 companies. When it’s elevated, the market is expecting future price change to be higher than it is today. To take it one level higher, VIX futures contracts look to price what the current VIX will be in the future. A second order effect if you will. What does today’s price movement tell us about the price movement in the future. In our first chart, we look at the current VIX futures contract and compare it to what the market expects for that contract 4 months from now. By comparing their prices, we can see what the market thinks today relative to where it will be in the future. When current volatility is expected to be higher than future volatility. The market is telling us things will calm down in the future from where it is today. Normally, the uncertainty about what will happen in the future, means that future volatility is more uncertain and should be higher than it is today.
We can see during periods when the blue line (current VIX futures) moves above the red line (futures price 4 months from now), we tend to be close to a market bottom. The z-score is measuring the statistical importance (in standard deviations) spread. The COVID shock to the world was an 8 standard deviation move. Normally, 3 standard deviations is considered a good indicator to look for a bottom. It also helps to consider other trading metrics like those we track weekly in our PRO-EYEs index to help identify a bottom.
As a leading indicator, we can consider the volatility of volatility (VVIX). What is the change in the volatility of the volatility indicator itself telling us? What we can see in recent months, that it has remained elevated compared to most of the last 2 years where on average, market players were not expecting rapid changes in prices. This started mostly when Russia started its troupe buildup along the Ukraine boarder and the US government warn of an attack in early December.
From this lens, we likely have not made an important market bottom yet, but these tools could help investors keep a PRO eye on it.
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