History of volatility index shows market not likely out of the woods yet — how to trade it

Volatility in the context of stocks and indices refers to the degree of variation or fluctuation in the price of a stock or an index over time. It is a statistical measure that reflects the extent of price movement, typically expressed as a percentage corresponding to the annualized standard deviation, a convention which, among other things, simplifies our understanding of and conversation regarding volatility over differing time frames. Options traders commonly refer to two types of volatility: “historical” or “realized” volatility and “implied” volatility. Realized volatility measures the actual price fluctuations of an underlying asset, like a stock, commodity, or index, over a specific period. Calculated from observed price behavior, “realized” volatility is, by definition, backward-looking; some also refer to it as “historical.” Implied volatility, on the other hand, represents the market’s expectation of future volatility over a future period. Unlike historical volatility, it is forward-looking and derived from the current price of options on the stock or index. The Cboe Volatility Index (VIX) Index is the most commonly cited measure of implied volatility, derived from a theoretical strip of S & P 500 options prices with 30 days to expiration; it represents the options market’s expectation for the volatility of the S & P 500 Index over the next 30 days. Recently, the VIX Index spiked viciously, exceeding 50 during regular market hours on August 5 — the first time since 2020. Many, myself included, regard big spikes in the VIX as contrary indicators. The flush in stock prices caused by a momentary, sometimes mindless (automated? algorithmic?) panic eventually settles down, so take advantage of the temporary discount in prices. Options traders expect volatility to settle down because it is a “mean reverting process.” Periods of unusually low volatility don’t last forever – although they can persist for remarkably long periods – eventually, some event stirs it back to life. Periods of high volatility will ultimately settle down somewhat, even if the market doesn’t recover entirely. The GFC provides a perfect example: the VIX peaked in late Q4 2008, while the S & P 500 Index hit a bear market low in Q1 2009. Here is a historical chart of the VIX Index over the past 34 ½ years. The yellow line represents the mean (give or take). The most recent spike is such a thin line on the chart that one can barely make it out, but it’s there. The VIX hit one of its highest-ever levels earlier this month. Also, is it virtually impossible to see on this chart? Friday’s close of 14.80 was just nine trading days later, well below the long-term mean. Traders and investors adjust their strategies based on past experiences and expectations, influencing both realized and implied volatility. This adaptive behavior can contribute to volatility’s mean-reverting nature. Market mechanisms, such as volatility targeting strategies by institutional investors and the effects of supply and demand on options pricing, play a significant role in driving the mean reversion of implied volatility. Market automation and speed have increased, and aggressive fiscal and monetary policy responses to market drawdowns conditioned investors to “buy the dip.” Every dip. Fast. I’ve admitted that I like the VIX as a contrary indicator, so at first, I attributed the quick rebound in the broad indices and plunge in the VIX as just a more nimble market response. Is it? Bernard Baruch once said, “The main purpose of the stock market is to make a fool of as many men as possible.” I’ve historically taken this to mean that the market will make a fool of all of us sooner or later. I’ve fallen victim to it many times, indeed. But then, what does mean reversion mean? The VIX didn’t revert to the mean. It snapped back and fell through it almost immediately, which got me thinking about another quote. “You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.”- Abraham Lincoln. So, I looked back through history to see what the S & P 500 30-day realized volatility was 40 days after a VIX Index spike above 35, as it did on August 5. Was there EVER a situation in the past 35 years where we saw such an increase in implied volatility and 40 days later experienced below-average 30-day volatility as the VIX is now implying? A spike above 35 itself is a rare event, occurring just 4% of the trading days over the past 35 years. Of those relatively rare events, only 5% of the time following a VIX spike like the one we recently experienced did S & P 500 vol fall below the mean. But 14.8, Friday’s closing VIX, isn’t just below the mean VIX; it’s WELL below. How often have we seen a 30-day realized volatility in this context historically? Over the past 35 years? Never. Not once. It’s not in the data. There’s a first time for everything, maybe this will be the first sub 15% 30-day realized implied volatility for the S & P following a VIX spike like the one we recently saw. If you think it’s unlikely, here’s another first. I’ve never recommended buying a strangle, particularly not on an index or index-related product like SPY , the ETF that tracks the S & P 500, but I’ll bite this time. SPY YTD mountain SPDR S & P 500 Trust (SPY) Here’s one way to play for a volatility spike through September 20: Buy SPY Sep. 20 $544 put Buy SPY Sep. 20 $567 call DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. 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