A New Way to Look at Market Volatility

• stevenplace
• March 10th, 2010

I’m always searching for different ways to approach and perceive the market– I feel that sticking to a set of knowledge without flexibility or adaptation will lead to underperformance in the market.

One relationship I’ve been watching was the relationship of smallcaps and the S&P. The rule of thumb is that when smallcaps are outperforming, that means there is an appetite for risk and beta-chasing in the market, and upside momentum should follow. However, we’re still in a period of a highly correlated market so while that signal is valid, I started to look for other indicators related to this relationship.

Enter the volatility indicies. We normally hear of the VIX, which is the normalized expectation of volatility 30 days out. This is based on the perception of market risk via the SPX options board. We also have the RVX, which is analagous to the VIX except it uses RUT options. So there are two measures for market risk, but they are different markets.

What happens when we compare the movement of these two tickers? The results are very interesting:

Now this method is by no means scientific, I simply eyeballed the past 2 years of data.

The top pane is the SPX, the bottom pane is the line chart for the RVX/VIX. So when the value is high, that means there is a higher perceived risk in smallcaps than the S&P, and the opposite at lower values. To smooth out the data, I used a 20 day moving average.

By looking at the key “turning points” in the moving average, we can see that this is a leading indicator in the markets. This makes sense– when higher premiums are being paid for “riskier” names, that means option players are starting to anticipate a slowdown in risk assets, which also include equities.

I’m not sure if I can derive any predictive power out of this relationship, but it is something worth looking into.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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