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Volatility of Volatility

In derivatives, complexity can build upon itself quickly.  It is difficult enough to understand the volatility of linear financial instruments such as stocks and bonds, but exploring the world of option volatility opens a whole new world of possible analysis.  The VIX index measures the short-term implied volatility of the S&P 500 index and has become a benchmark for volatility in equity markets.  Just within the past few years, individuals and institutions have been given the ability to trade directly in implied volatility through instruments such as VIX futures, VIX future options and the ETN’s VXX/VXZ.  When looking at the implied and realized volatility of the VIX, we are effectively looking at the volatility of volatility.

10 day Volatility of the VIX has spiked to extreme territory

With financial data we often look at historical time series to provide a perspective for us to make subjective judgments.  In this case, we can see that the 10 day volatility of the VIX has spiked to levels not seen since the heart of the crisis.  As an arbitrary case, let us just look at the times in which the 10 day volatility of the VIX spiked above 150%.  If we look at the S&P 500 return 30 and 60 days after breaking the 150% barrier, we can see the following returns for the S&P 500:

Returns following spikes in Vol of Vol were negative on average

It is difficult to draw conclusions from this simplistic analysis, but one thing that stands out to me is that the highly negative returns (<-5%)  followed the downgrades of Ambac/MBIA and fall of Countrywide (6/6/2008) and after the collapse of Lehman Brothers (09/16/2008).  If you look at the other data points, the returns were not nearly as severe and in many cases were positive.  In other words, how significant is this current crisis in confidence?  With most fundamentals in the United States currently on better footing, how large of a dislocation could we see from the crisis in Greece?

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