The Door Is Open For A Spike In Volatility

In 2017, I won the Charles H. Dow Award for my paper, “Forecasting a Volatility Tsunami.” In the paper, I discussed the relevance of dispersion in evaluating the Volatility Index (VIX). I found that nearly each spike in the VIX was led by a contraction in the dispersion of volatility. To measure dispersion, I use Standard Deviation over the past 20 days. At the end of last week, dispersion for the Volatility Index dropped from 2 to 0.54 as the higher levels rolled out of the lookback period. I've marked prior instances where standard deviation has been this low. Currently it's at the lowest level since just before the Covid Crash and the mini-2018 bear market.

It isn't just the S&P 500 VIX (Volatility Index) that's seen a major drop in its daily dispersion. The volatility indices for the Russell 2000, Dow Jones Industrial Average, and Nasdaq 100 have also see a decline in dispersion. Below is a look at the standard deviation for a composite of the four volatility indices. Orange lines mark prior instances of the current level (under 0.60).

Contraction in dispersion opens the proverbial door for volatility to move higher. As I discussed in the “Forecasting a Volatility Tsunami” paper, not all contractions are followed by volatility spikes but nearly all spikes are preceded by these types of contractions. In this week’s Thrasher Analytics letter, I discuss in further detail some of the other developments in volatility I’m keeping a close eye on.

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