facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
What Does a Volatility Contraction Mean?  Thumbnail

What Does a Volatility Contraction Mean?

Volatility is how fast and wide prices spread out. 

What is it? 

The Cboe Volatility Index® (VIX® ) is considered by many to be the world's barometer of expected stock market volatility.

The VIX Index is based on real-time prices of options on the S&P 500® Index (SPX) and is designed to reflect options traders' consensus view of future (30-day) expected stock market volatility.

The VIX Index is often referred to as the market's "fear gauge" because it spikes up when stocks fall, and fades when the stock market trends up. 

The Cboe Realized Volatility Index (RVOL) is one of the Realized Volatility Indices designed to provide the magnitude of daily price movements by measuring the annualized standard deviation in the daily price return of an underlying over a specific period. 

Realized volatility (RVOL) is historical, actual, volatility, while implied volatility (VIX) is forward-looking, future expected volatility implied by options prices.  

Implied volatility (VIX) and realized vol (RVOL) is in a volatility contraction, after shifting from an elevated expansion stage where it cycled around 20%, to a new lower state.

What does it mean?

It's like the year after a hurricane in Florida or fire in the mountains of Tennessee, and its memory is fading, so people aren't extrapolating the past into the future. Once they stop fighting the last battle and don't expect another one, the demand for insurance protection declines and becomes a better relative value. 

An old adage, When the VIX is low it's time to go, when the VIX is high it's time to buy. 

But that refers to go away from the stock market (selling stocks when implied vol is low and prices are high), and buying stocks when the VIX is high (and stocks are low.)

There's a lot more to applying it for tactical decisions to increase/decrease exposure,  but the by and large is volatility contractions are eventually followed by volatility expansions, and vol expands the most when prices fall fast and wide. 

While the options market expects lower volatility over the next 30 days, active risk managers and tactical investment managers pursuing risk-adjusted asymmetric investment returns may be inclined to hedge off exposure while protection is a better deal. 

Mike Shell is the founder, President, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of Asymmetry® Managed Portfolios.  Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies. Shell Capital provides investment advice and portfolio management to clients with separate accounts at Goldman Sachs Advisor Solutions with an investment management agreement. The observations shared on this website are for general information only and should not be construed as investment advice to buy or sell any security. This information does not suggest in any way that any graph, chart, or formula offered can solely guide an investor as to which securities to buy or sell, or when to buy or sell them. Securities reflected are not intended to represent any client holdings or recommendations made by the firm. In the event any past specific recommendations are referred to inadvertently, a list of all recommendations made by the company within at least the prior one-year period may be furnished upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities on the list. Any opinions expressed may change as subsequent conditions change. Please do not make any investment decisions based on such information, as it is not individualized advice and is subject to change without notice. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but are not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. If this website contains information regarding Options Trading, please read the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). Options involve risk and are not suitable for all investors. The views and opinions expressed in Asymmetry® Observations and Asymmetric Investment Returns are those of the authors and do not necessarily reflect the position of Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.