Beginners Series Webinar: Join us on Friday, October 11th at 2 PM (ET) for our NDW Beginners Series Webinar. This week's topic is: Navigating the Models Page. Register Here

The CBOE SPX Volatility Index (VIX), often referred to as the “fear gauge,” has seen a notable uptick as we approach the US Presidential election and a critical period for FOMC decisions. However, realized volatility over the last month has been quite low. The VIX is intended to measure the annualized standard deviation of returns over the next thirty days. Realized volatility looks at the actual annualized standard deviation of returns across a period such as the last thirty days. As of close on 10/09/2024, the VIX is at 20.86 while the last thirty days of realized volatility sits at 10.10.

Historically, the VIX tends to overestimate volatility over a coming period, so it’s normal for the VIX to be higher than trailing volatility. That said, the current difference between trailing realized volatility and the VIX is in rare territory. For context, the present spread between the two would place in the 94th percentile since the VIX’s inception while the ratio of the VIX to realized volatility is in the 98^th percentile. With the market pricing in significant increases in volatility, should we be concerned this is a sign of worse things to come?

To answer this question, we placed the spread between the VIX and realized volatility into deciles and then looked at the forward returns of the S&P 500 for each group since 1990, which is as far back as VIX data goes. Viewing the table above, the performance for the tenth and highest spread decile (which is where we are now) sticks out, especially at shorter time horizons. Across all the forward time horizons, the decile with the highest difference between the VIX and realized volatility also has the highest returns. Most notably, the one-week and one-month forward return is double that of the next closest group. In addition to strong returns, the top decile has also shown a higher hit rate.  Compared to the general market average, the top decile had a 5% and 6% higher probability of generating positive one-month and three-month returns, respectively. For those looking to see when prior periods have occurred, you can see a graph of the S&P 500 with the times in the top decile shaded in purple.

One thing to note is that the top decile has a higher overall VIX level, which can be positively correlated to returns at extreme levels (e.g., 2009, March 2020, etc.), which may influence the positive returns. However, the trend of greater performance with greater VIX to realized volatility holds up when looking at the ratio of VIX divided by realized volatility, which appears to not suffer from the same issue of higher overall levels, as seen in the table below.

Humans inherently dislike uncertainty, especially when it comes to money and the potential downside. When the VIX is significantly higher than recent realized volatility, it might be an indication that the market is overly fearful. Presently, the election appears to be a large source of volatility, and those looking for additional context around the subject should read today’s featured article on the matter.

On Monday, 10/8, the S&P 500 Volatility Index (VIX) was up nearly 18% while the S&P 500 (SPX) was down a relatively modest 1%. One reason for outsized move in the VIX may be that the market is expecting a volatility to pick up between now and election day. The VIX is calculated using the implied volatility of S&P index options expiring in the 30 days, so Monday was the first day when options expiring post-election day were included.  The presidential election can have major implications for the economy and the market as the winner will shape foreign and domestic policy for the next four years, so it’s not surprising that we might see an increase in volatility in the weeks leading up to the election. This year, there is perhaps more uncertainty than usual about the outcome of the election as many polls have shown that the race is a dead heat. With odds between the candidates roughly evenly split, should we expect to experience more volatility than unusual this year? Would there be less volatility leading up to election day if one candidate was leading by 10 points?

To get a better understanding of how the state of the race affects the state of the market we looked at the final polls for every election since 1952 (and polling averages for the two most recent elections) and the returns and volatility of the S&P 500 in the October before; we used two methods to gauge volatility – annualized standard deviation of the daily returns for the month and index’s range for the month – calculated as the high minus the low divided by the prior month’s close. The results of our study are shown in the table below.

Our hypothesis going in was that we might see increased market volatility in October in years when polling showed a particularly tight race.  However, the data doesn’t appear to bear that out. There are some years in which a close presidential race was accompanied by an unusually volatile October, as was the case in 2000. But we also know that this was during the dot com bubble. Four years later in 2004, an even tighter presidential race (at least based on the final polling) saw significantly less market volatility. Meanwhile, October 2020 was much more volatile than October 2016, even though the polling averages showed a less competitive race in 2020. Of course, this was also during the COVID-19 pandemic, suggesting that volatility or lack there of has less to do with the competitiveness of the race for the White House than the existing market environment. While we typically expect to see some volatility around election season, the data suggests that we shouldn’t expect an outsized increase this year just because of a close contest.

Daily Option Ideas for October 10, 2024