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Historic Volatility Divergence from Implied Volatility as a Broad Market Sell Signal

Using volatility to forecast market direction is a commonly used technique.  In this post, I show an observation that has peaked by attention along with the some theoretically justification for my directional call.

Below is a three series chart of SPY underlying price (beige), calculated historic volatility (red), and implied volatility (blue).




The first observation that I want to draw attention to is that SPY 30 day historic volatility has flat lined right around 30% over the past 2+ months.  Historic volatility is a measure of the variance of underlying asset price changes.  Historic volatility is important to note because this is the amount of variance the underlying has actually experienced over a given time interval, in this example calculated based on the trailing 30 days. 

Notice that historic volatility is not necessarily subject to fall when the equity markets rise.  It is entirely dependent on the price path of the underlying. 

This differs from implied volatilty. Implied volatilty is calculated based on the price premiums of options on the underyling.  Implied volatilty almost always moves opposite the direction of the underlying - SPY up, VIX down, and visa versa.  This is because the put premiums signal fear in the market as investors look to buy protection for their long positions on the underlying.

Now that we have covered the basic background of each indicator, time to get into the premise of why this would be a good time to sell out of stock positions, buy puts, or perhaps buy VIX calls.

If you accept that the actual variance of the SPY is going to remain right  around 30% for the time horizon you choose through you position, buying puts serves as a worthwhile insurance policy for a long position in the market.  If the market continues on its upward ascent with a variance measure still near 30%, you will be able to capture a profit from the spread between what you paid for the volatility and the actual variance of your portfolio (assumed to be the same as the SPY).  While the put positions you initiate would expire worthless, your portfolio gains will outpace the cost of insurance, again returning to the constant 30% historic volatility assumption.

If you accept that implied volatility costing less than our historic flatline level of 30 is a bargain, it logically follows that this would be a time for a portfolio manager to "accumulate variance".  This is to say, buy more puts or get long implied volatility, in one way or another.

Now here is the theory behind my direcitonal prediction:  If you accept that funds will accumulate variance when it is cheap, as it has been for the past few days, a sell reaction in the market would follow, if it ever was going to come to fruition.  It is a problem of order of operations. 

Why would a (for the sake of argument) HUGE fund want to sell out of equity positions before they buy implied volatility?

They wouldn't.  They would be raising their own cost of insurance.

To maximize their own gains, they would want to buy the implied volatility, while it remains cheaper than historic.  Additionally, if they plan to be a net-seller into the market (in a medium term), any selling pressure is only going to act as a sell-defeating feedback loop to their own cost of insurance.  This leads to the conclusion that any large fund that uses volatility to hedge AND plans on liquidating net-long exposure, will follow this order of operation: Buy volatility first, sell equities second.  By following anything other than this sequence, they only shoot themselves in the foot.

Anecdotally, the observation has proven to be correct.  When implied dipped below historic volatility in late October, a sharp sell-off followed.  Obviously there are 10,000 reasons to be either long or short this market and the headline risk is another reason to be long the upcoming calculated volatility, but I think as a technical signal this observation shouldn't be ignored.  The logical sequence of events for how large market participants would buy volatility is clear, at least in my mind, and this observation makes me bearish on the direction of S&P 500 equities in the upcoming weeks.