Volatility: Not extraordinary after all

On August 8, 2011, the VIX index, often referred to as the fear index, rose to 48%. It was the highest point reached in 2011—the VIX has exceeded the 40% threshold only three percent of the time in the past 20 years.

Although the VIX index experienced several spikes during this year, for the most part it hovered around 20% to 25%—its long term average.

“Market volatility has come down from its peak, it continues to hover in the above-average range of 25% to 35% on the VIX,” says Ioulia Tretiakova, vice-president and director of quantitative strategies at Pur Investing Inc. “While 2011 was higher than average, it was not extraordinary as volatility remained under 25 for the most part of the year.”

The VIX measures the prices investors pay for options as portfolio protection on the Standard & Poor’s 500 stock index. When fear is on the rise, traders resort to buying options, which pushes up the implied volatility.

Generally, any point north of 20 signals a rise in market volatility while above 40 is a sign that emotions in the market are extreme.

Get ready for more shocks

Compared to the 2008 financial crisis, 2011 experienced a shorter streak of elevated volatility. In 2011, the highest point reached on the VIX was 48 and it stayed elevated above 40% for approximately eleven days. In 2008, it soared to 80.86% and stayed above the 40% threshold for three months. But 2011 was more volatile than the dot-com crash of 2000 and the Asian Market crash in 1997; in neither case did the VIX break 40%.

Although there are no definitive explanations for the cause of 2011’s volatility, it’s clear the European debt crisis was a significant factor, says Tretiakova. However, it is unlikely that one single event in the market is responsible for the spike. Eventually, market volatility will fall back to the average range of 20% and 25%.

“Studies have shown that individual news events mean nothing over time. It may drive markets down, but it will bounce right back to the level it was at before the news,” she explains. “Traders will disagree with me, but if you look at their profit/loss sheets, I think it will prove that over time news neutralizes itself in the marketplace.”

While some investors believe the greater uncertainty in global markets will lead to increasingly higher market volatility, Tretiakova says this is unlikely to occur.

“Unlike equity markets that are expected to grow over time, volatility cannot be ever increasing. One could make a simple argument that, occasional turbulence aside, if markets were to become consistently more and more volatile, at some point they would break down and cease to exist. Historical data shows that volatility indeed exhibits mean reversion, oscillating around some long-term means.”

What the higher level of uncertainty has ushered in, however, is an increase in the frequency of volatility shocks. Going forward investors should be prepared for more volatility spikes. That is, as volatility breaks through the 20% on the VIX, investors act more cautiously as this is a signal that people should take a more conservative stance with their portfolio, rather than stand by and do nothing.

“We’re having more shocks than 2008 and the tech bubble, so when you’re managing to constant risk and reacting to these frequent shocks, you’re portfolio will be in better shape,” says Tretiakova