Buyside Strategies EQD Research Volatility

EQD Research: In The New Year VOLQ Offers Insight Into The Mind Of The Market

Jan 4, 2021

By Russell Rhoads,
head of research

As 2020 comes to an end, equity markets are trading near all-time highs, but the associated volatility indices remain at elevated levels. For instance, as of December 31, the Nasdaq-100 (NDX) is up over 47% for 2020 and 82% higher than the pandemic associated March lows. Despite the stellar performance of the NDX, VOLQ finished the year at 23.36, almost six points higher than the long term average of 17.60. So why is VOLQ still at historically elevated levels despite the strong performance of the underlying index?

One answer is that the market has a pretty short memory and 2020 was the most volatile year for stocks in over a decade. VOLQ history is available going back to 2014 with the chart below showing the high, low, and average VOLQ by year. On this chart, 2020 is an obvious outlier with VOLQ reaching the upper 70’s and averaging just under 30 in 2020.

Another reason VOLQ remains elevated is that VOLQ, like all volatility indices, is a forward looking measure. Despite good news on the vaccine front, there is still a lot of uncertainty about the long term economic impact of the pandemic. Also, with respect to the NDX, there is uncertainty as to how stocks that have done well during the transition to working, shopping, and doing everything else from home, will perform once the worst of the pandemic is behind us.

Many market observers will look at VOLQ versus NDX realized volatility, despite VOLQ acting as a forward looking measure. There is some use in going this route as there is a very strong relationship between NDX historical realized volatility and VOLQ.  The chart below shows the daily price action for VOLQ and realized volatility for the previous 21-trading days. The 21-trading day figure is used for realized volatility as VOLQ is a 30-calendar day measure which most often matches up with 21-trading days.

The dramatic part of this chart is on the left where both VOLQ and realized volatility are basically moving up together and then dramatically disconnect. The disconnect, where VOLQ starts a downtrend and realized volatility continues the uptrend can be traced back to March 23, which is the trading day after NDX bottomed out just below 7000. That forward looking aspect of VOLQ is why many traders place it right next to NDX on their trading screen.

The more recent price action, on the right side of the chart, shows a disconnect between VOLQ and realized volatility. Specifically, realized volatility is trending down, while VOLQ is holding at higher levels. This relationship, along with the relationship between VOLQ and NDX should be watched closely in order to get a read on what option traders are thinking with respect to prospects for the NDX going into 2021.

When both NDX and VOLQ are trending in the same direction it may be a signal that the derivative markets see things a bit differently than the delta one or underlying market. An example of this occurred in early 2018 leading up to a spike in VOLQ and a quick selloff in the NDX. The chart below shows the daily price action for VOLQ and NDX over the first two months of 2018.

In January 2018 both NDX and VOLQ trended higher, in sync with each other.  This is an indication that option traders were paying up for options, even as stocks were moving up. Typically, more index puts than calls trade on a daily basis, so both trending higher means option traders are concerned about or anticipating a drop in the underlying index. This results in rising implied volatility priced into NDX option and an elevated VOLQ level.

There is a lot of optimism regarding the state of the world as we have reached a new year. However, despite the calendar changing over, there are plenty of risks lurking that may have a negative impact on the direction of stocks. A consistent measure of expected volatility, like VOLQ, should help traders navigate whatever 2021 brings.