Fear and the VIX market in the short-run

The VIX index spiked in the last month in response to the sell-off in the stock market, but has now moved back within three points of its average for the last year. It has historically been viewed as a good measure of risk uncertainty. so there has been a focus by many investors on any increases in the VIX in expectation of a market sell-off. We had a contemporaneous change in the index with the decline in stocks, but the fall in the last two weeks suggests that the market has discounted its fear and is now back to only slightly above the level seen for the last year.

Unfortunately, using the VIX index as a forecasting tool in the short-run has some problems. While there is a strong negative daily relationship between the S&P 500 and the VIX on a contemporaneous basis, the relationship seems to disappear once you lag the VIX by one day. The short-term change in the level of the VIX does not have skill at telling us what may happen in the future to the stock market. Hence, in the short-run, it can only be used to provide insight on whether a change in the stock index is being validated with higher option uncertainty.

Theoretically, we may want to believe that the line of causality runs from higher risk to lower returns, but the empirical results for a linear model are less persuasive. The trade-off between risk and return is more complex than a simple rule of selling stocks when the VIX spikes.

The best research I have seen on this topic was done by P. Giot, "On the relationships between implied volatility indices and stock index returns." (See http://ww.core.ucl.ac.be/econometrics/Giot/Papers/IMPLIED2_i.pdf for details.) He shows that there is a much more complex relationship between the VIX and stock returns based on the level of volatility and the direction of the market. This will not be seen in simple linear models.

What may be important when using the VIX is knowing the overall level of risk relative to the mean. Like what has been found with most of the GARCH models, volatility has a tendency to spike and then decay to a mean. It is the relationship of volatility to its average and not its contemporaneous level with stocks that may be the most important information for equity investors when looking at the VIX.