07 Dec 2020 3 min read

The VIX and the vax

By Tim Armitage

The calm inspired by progress towards a COVID-19 vaccine is certainly good news, but history suggests low volatility in equity markets shouldn’t make investors complacent.


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Do you know any finance-obsessed pessimists with dystopian concerns about artificial intelligence? If so, I can recommend “The Fear Index” by Robert Harris as a potential stocking filler this Christmas.

It has an indescribably silly plot centred on a trading algorithm literally taking over the world. If nothing else, it has given us the spectacle of Richard and Judy discussing implied volatility.

The Fear Index in question is, of course, the Chicago Board Options Exchange Volatility Index – or the VIX to its friends. Good news in recent weeks on COVID-19 vaccines has seen that measure of market ‘fear’ collapse. In late November, the VIX even dipped below 20 for the first time since February; it had peaked above 80 at the height of the crisis in March and stood at 40 as recently as the end of October.

This fall in the VIX has gone hand-in-hand with tightening credit spreads and surging equity markets. Taken at face value, the VIX at 20 suggests options traders see the probability of an equity market correction of more than 10% over the next month as being around one in 20.

Risk has not disappeared, but perceptions of it seem to have moderated substantially. This is understandable, with markets entering calmer waters lately not just because of vaccine developments but also in light of the resolution to the US election.

This shifting sentiment can create opportunities. The VIX itself isn’t directly investable, but liquid monthly futures contracts based on it are. While we rarely take outright positions in VIX futures, they can provide a useful way of tactically taking advantage of event risks. The US election at the start of last month was a prime example; the VIX rose to 40 in the run up to 3 November, diverging from equivalent indices in other markets (such as the VSTOXX Index in Europe), enabling us to take ‘relative value’ positions between markets in anticipation of the political risk premium fading post-election.

The VIX is in

Yet while equities have generally been buoyant since the election and vaccine announcements, it is worth bearing in mind that the VIX has historically been a contrarian indicator. When option traders panic, returns have subsequently tended to be very healthy; when they relax, it is time for the rest of us to worry.

The chart below shows the average 12-month forward US equity returns from various starting levels of the VIX, with data calculated from 1990 onwards. The halcyon days have been when the VIX is above 40, not at or around 20.

When thinking about the state of the world in the year ahead, the vax is undoubtedly good news. When thinking about equity market returns over the next 12 months, the tumbling VIX is not.

Tim Armitage

Quantitative Strategist

Tim is a former musician reincarnated as a quantitative strategist, and subsequently spends more time writing code than songs these days. When not thinking about swaption strategies and risk indicators, you’ll find him running marathons, and secretly hoping there’s a day his three sons form a band that becomes the next Kings of Leon.

Tim Armitage