One of the most predictable features of the stock market is its volatility. While consistent price forecasts are very hard to accomplish, the tendency of index volatility to “cluster” makes it much easier to predict a range of future volatility over the short term. Periods of low volatility are of non-randomly long duration and concentration, and volatility rarely spikes straight up from a low volatility cluster without noticeably increasing beforehand. This inherent predictability is extremely useful to develop a series of warning indicators and risk-off triggers — both to protect a portfolio, as well as to pinpoint times in a strong bull market that have an increased probability of large adverse movements to come. 

As most really bad things in financial markets happen in high volatility environments (just think back to the multiple 10%+ daily moves in either direction that we were facing in March of 2020), being forewarned is a huge advantage. We can prepare, anticipate and react with heightened situational awareness.

Volatility Clusters

The tendency of index volatility to cluster is well-documented going back to Bernoulli in the 1960s, albeit mostly in dense academic papers. Fortunately, some recent blog posts provide very accessible information that make the concept easily understandable for non-math geeks. Breaking The Market makes a strong case using simple visual examples.

“Volatility always climbs first going into a big spike. It’s not a purely random black swan type event with no prior signal as it often feels. High volatility doesn’t come out of nowhere. It builds, which means it doesn’t need to take you by surprise if you are paying attention.
Future volatility depends on past volatility.” Breaking The Market

A table of return correlations in the post proves the point that “If the absolute return from the prior day correlates with the absolute return on the following day, it means future volatility depends at some level on prior volatility. 
You can make an educated prediction for near-term volatility.”

Practical Use Cases

For my own portfolio, I use systematic implementations of volatility-based signals that are at the core of my long-term investment strategy, as well as several short-term trading setups. One of these is currently flashing a strong short-term warning.

Aligning portfolio positioning with specific time frames is very important. It is a theme that runs through my entire investment process. For example, it regularly occurs that I am invested in stocks over the medium- and long-term, while expecting a short-term correction with a high probability, as I currently do. In practice, I solve this conundrum by overlaying short-term trading positions over an ETF-based investment portfolio.

Short-term Rally Exhaustion in the Current Market

A useful indication of potential trouble on the horizon, while things still look to be going exceedingly well, is when traditional relationships between volatility measures and the underlying equity index are getting out of whack. 

SPX / VIX Correlation
It is well known that the VIX, which measures implied stock market volatility based on SPX options, tends to fall in a rising stock market and vice versa — SPX and VIX usually are negatively correlated. Whenever this correlation starts to become positive, it indicates that something is wrong underneath the market’s surface: Options have become unnaturally expensive, which shows up as rising implied volatility, and this is a fragile state that normalizes quickly — often in the form of falling stock prices.

Using a 10-day SPX / VIX correlation threshold of 0.5 as a signal has flagged major corrections (e.g. Volmageddon in 2018 and the Covid crash of 2020) in the past years well in advance. While the indicator is sometimes early by 6-8 weeks, it is interesting to note that we saw lower prices than the signal date within 3 months in every single instance. 

That’s a very rare hit rate, which makes for an excellent medium-term correction warning signal.

SPX / VVIX Correlation
For traders that are more short-term oriented, it is worthwhile to pay attention to the SPX / VVIX correlation, which yields a larger number of and more timely signals than using VIX. VVIX is a measure of the volatility of volatility, which has a tendency to become highly correlated to the S&P 500 when a strong market rally is very close to a point of exhaustion.

An almost immediate consolidation followed in every instance in the past 5 years (albeit only weakly in late 2017 and 2019) when using a 5-day SPX / VVIX correlation threshold of 0.7 as a signal. This consolidation can take the form of a short-term correction in price or in time. (“In time” refers to a pause in the rally for a couple of days or weeks, but absent a significant price decline.)

For practical trading purposes it is important to note that a lower price than the signal date’s was always reached within 2-5 weeks — even in a sideways consolidation. A short position could have been closed without a loss within that time period, allowing a low risk set-up for capturing the potential gains of a larger corrective move.

As shorting in a bull market is one of the most difficult trades to pull off successfully, that is quite something!

On Thursday, August 12th, the SPX / VVIX signal triggered once again. The 1-year chart above shows more clearly what can be expected, if the pattern continues to hold: Either a price correction should begin within days, or else a sideways move can be used to exit any short position at break even within the next 2-4 weeks. In addition I would set a stop loss 50 – 100 points above the current price, which would define my maximum trade risk and position size (a 100 point stop loss was never triggered during the past year).

(Added in 2023:) A 5% decline in the beginning of September 2021 followed a cluster of August SPX / VVIX signals and four months after this article was written the 2022 bear market began. During the formation of a top both indicators flashed warning signals for an impending correction in November and December 2021.

Market Regime Indicator

Most investment and trading strategies can be improved on by using a market regime filter, as each strategy will work best in a specific market environment. The simplest way to categorize the stock market is as either a risk-on (quiet, low-volatility bull market) or as a risk-off (choppy, volatile bear market) environment. These basic categorizations can have a huge impact on long-term investment performance, as they make concentrated equity exposure or the responsible use of leverage much less risky.

I have implemented and written in detail about the use of the shape of the VIX Futures Term Structure as a risk-off warning signal for quite a while, and it continues to be one of my favorite indicators, enabling me to run my investment portfolio with confidence.

Around 80% of the time the VIX Futures Term Structure will be in “contango” — an upward sloping curve, where each futures contract further out in time will be more expensive than the nearer term one. I consider this to be the “normal” state of things, when stocks will usually give us excellent, reliable returns. 

A recent interview with Kyle Schultz on the Better System Trader podcast goes into interesting detail, and arrives at similar conclusions.

The reason for this predominant state of contango is convincing: VIX futures can be used to hedge an equity portfolio because of the negative correlation between the S&P 500 and the VIX. Market participants naturally pay a premium for such protection, as one would expect to pay for any kind of insurance – the longer one wants protection for, the more expensive it gets.

Going to cash when this curve inverts (slopes downward) will help to avoid strong corrections and bear markets. How I use this in combination with trend-following and fundamental indicators in a systematic investment strategy is described in the Meta Strategy eBook (free registration required).

The idea is very simple and is based on the premise that distinct market regimes tend to stick around for a period of time (volatility regimes cluster): in a normal environment taking risks and running risky strategies (e.g. short volatility strategies or leveraged equity exposure) is likely to be rewarded.

“Not normal” is dangerous and can be defined by a volatility structure that is breaking the rules: if market participants are paying more for the shorter duration VIX futures contracts than the longer ones, then something is amiss. Volatility is expected to be very high in the near future – a market crash is seen as a likely outcome by many investors and it pays to be careful.

In contrast to trend-based models, a danger signal based on the term structure of VIX futures reacts more dynamically and triggers a warning earlier in a market displaying significant changes in volatility. 

There seems to be a significant change in market structure (owing partly to the dramatic rise in options volumes), such that swift volatility shifts have become more common in recent years. This makes it likely that a volatility-based regime indicator may perform better than a purely price-based trend measure (e.g. a long-term moving average strategy).

Good luck with your trading, and thank you for reading!

David

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