Does implied stock market volatility (IV) predict stock market returns? In their March 2018 paper entitled “Implied Volatility Measures As Indicators of Future Market Returns”, Roberto Bandelli and Wenye Wang analyze the relationship between S&P 500 Index IV and future S&P 500 Index returns. They consider volatilities implied either by S&P 500 Index options (VIX) or by 30-day at-the-money S&P 500 Index straddles. Specifically, they each day:
- Rank current S&P 500 Index IV according to ranked tenth (decile) of its daily distribution over the past two years. If current IV is higher than any value of IV over the past two years, its rank is 11.
- Calculate S&P 500 Index returns over the next one, five and 20 trading days.
- Relate these returns to IV rank.
They calculate statistical significance based on the difference between the average IV-ranked log returns and log returns over all intervals of the same length. Using daily data for the selected variables during December 1991 through November 2017, they find that:
- IV relates positively to S&P 500 Index returns at horizons of one, five and 20 trading days. However, the effect concentrates in IV rank 11 (see the chart below), which comprises less than 1% of daily observations.
- Findings are statistically significant for 1-day and 5-day return horizons when using the VIX as the IV metric, but associated returns are economically small.
The following chart, taken from the paper, summarizes 1-day, 5-day, 20-day average S&P 500 Index returns by VIX rank over the full sample period. Results suggest an exploitable effect for VIX rank 11 (2-year VIX high).
In summary, evidence indicates that S&P 500 Index returns are unusually high in the short term after extreme VIX spikes.
Cautions regarding findings include:
- Analyses for 5-day and 20-day returns apparently use overlapping return intervals, thereby introducing large return series autocorrelations which would overstate statistical significance if IV ranks cluster in the time series.
- A related point is that the study does not include a portfolio-level analysis outlining a times series method of exploiting findings (unambiguous entry and exit points, with trading frictions).
- As noted, rank 11 (2-year VIX highs) opportunities are rare (54 out of about 6,000 observations).
- If these rare opportunities cluster, investors cannot exploit them independently.
- Findings may be sensitive to parameter settings, such as the 2-year lookback interval used to assign current IV rank. However, the authors report that findings are not materially different for a 1-year lookback interval.
See also “Stock Market Performance Around VIX Peaks” and “VIX and Future Stock Market Returns”.
Frequently Asked Questions
What is implied volatility and how does the VIX measure it for the stock market?
Implied volatility (IV) is the market's expectation of future price variability, derived from option prices. In the study, S&P 500 Index IV is measured either by the VIX, which is implied by S&P 500 Index options, or by 30-day at-the-money S&P 500 Index straddles.
Does a high VIX predict higher future S&P 500 returns?
A high VIX is associated with higher short-term S&P 500 Index returns, but the effect is concentrated in extreme spikes. Over December 1991 to November 2017, the relationship was positive at 1-, 5- and 20-day horizons and statistically significant at 1 and 5 days when using the VIX, though the associated returns were economically small. The effect centers on VIX rank 11 (a 2-year high), which makes up less than 1% of daily observations.
How do you rank the VIX against its past two years to test for return predictability?
Each day, the VIX is ranked by decile of its daily distribution over the past two years, with a rank of 11 assigned if it exceeds every value in that window. Researchers then compute S&P 500 Index returns over the next 1, 5 and 20 trading days and relate them to the rank. Statistical significance is based on the difference between average rank-based log returns and log returns over all intervals of the same length.
Is a 2-year VIX high a reliable buy signal compared with other VIX levels?
A 2-year VIX high (rank 11) is the only VIX level where the study finds an apparently exploitable effect, with S&P 500 Index returns unusually high in the short term afterward. Other VIX ranks show little of the positive relationship, which concentrates in rank 11. However, the study offers no portfolio-level analysis with defined entry and exit points or trading frictions, so it does not establish a tradable signal.
What are the limitations of using VIX spikes to predict stock market returns?
The VIX spike effect has several caveats: 5-day and 20-day returns apparently use overlapping intervals, which can inflate statistical significance if VIX ranks cluster over time. Rank 11 events are rare (54 out of about 6,000 observations), and if they cluster, investors cannot exploit them independently. Results may also depend on parameter choices such as the 2-year lookback, though the authors report similar findings with a 1-year lookback.