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    Monitoring VIX for rise in volatility

    Whilst the world keenly awaits the outcome of a sell-off or break to new highs, we take a look at the relationship between VIX and the S&P500, which suggests volatility may be about to rise regardless of the subsequent direction. 

    VIX cannot remain suppressed for ever
    Along with every other analyst and trader I have been keenly watching price developments on indices for signs of a top. The S&P500 continues to struggle to break to new highs yet stubbornly holds above key support levels. Whilst I do not know for sure the timing or direction of the next break I can make one time-tested assumption: Volatility is bipolar and will always switch between low and high volatility, within various degrees. 

    VIX can help confirm a top may be underway
    A lower Volatility Index (VIX) is usually associated with calmness in the markets (or complacency) and a higher market with fear. That does not necessarily always mean trends on stocks will be rising with a lower VIX, as VIX will be lower if stocks trade sideways and in ranges. However above you can see the strong inverted correlation between SP500, with a very prominent relationship when stocks drop suddenly and VIX soars higher. As we trade near the all-time highs then any upside burst in VIX is likely to confirm a sudden sell-off on stocks, and related moves in global markets. 

    Below I have outlined a distribution of price changes for VIX, so we can use the assumption that if IX rises by a certain amount it is more likely to be part of a larger sell-off in stocks.

    Using VIX and Stocks to time other markets
    As stocks are an excellent barometer of risk and the S&P500 is considered a global benchmark for stocks, the S&P500 can be a useful index to follow regardless of which market you trade. If, for example, you trade USDJPY then you can follow S&P500 in tandem to use as a confirmation indicator for JPY inflows (as a safe haven). If there is panic in the markets, more often than not JPY will strengthen and S&P500 will fall. Therefor having an appreciation of VIX, its relationship with stocks and typical levels we can expect on a given day can help you quantify global sentiment at a glance. 

    Seeking tail risk days
    The standard deviation bands represent 68% of the frequency distribution, so roughly speaking we can assume 2/3rd of close-close changes on VIX to land between -1.5 and 1.4 points. The further away from this we get (in either direction) represents a more volatile yet historically less likely movement. It is these 'tail risks' we are monitoring as they will likely represent a larger move in stocks on a per-day basis, with the assumption we'll see a more bearish continuation of stocks if they do indeed drop from highs. 

    As the data effectively represents a % change for VIX, the 'arithmetic mean' is a daily change % of 0.6%. Interestingly the median (middle and most frequent number in the series) is negative but this would make sense if we take the assumption that volatility goes up very fast in times of panic, yet retreats back to the mean in a slower pace as investors regain their nerves.

    Above we can see the correlation between the daily change of SP500 and VIX is 0.64 (64%). This is not as tight a correlation as I would have initially expected, however this is taking into account both the magnitude and direction of the move for S&P500 in relation to the same metrics for VIX. In a separate test I will check the correction for SP500 up and down days’ vs VIX up and down days, where I would expect the correlation to be in the high 80's at least (possible lower 90's). A quick eyeball of the charts suggests the direction alone between VIX and S&P500 is very strong but will follow up in a later post alongside other, tradeable markets.

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