Stock market fluctuations quantified: Introducing two novel indicators to gauge market instability
In the realm of financial markets, volatility is a key factor that influences investor behaviour and market dynamics. Traditionally, the Cboe Volatility Index (VIX) has been the go-to measure for stock market volatility, particularly the S&P 500's expected changes over the next 30 days. However, two new indices, the Cboe S&P 500 Spot Volatility Index (SPOTVOL) and the Cboe S&P 500 Left Tail Volatility Index (LTV), have emerged as powerful tools for sophisticated investment and risk strategies.
## The VIX: A Brief Overview
The VIX, also known as the "fear gauge," measures the market's expectation of 30-day volatility implied by near-term S&P 500 index options. It is derived from a wide range of out-of-the-money S&P 500 call and put options, reflecting expected volatility regardless of direction. A higher VIX indicates higher expected volatility (more uncertainty/fear), while a lower VIX indicates calmer markets.
## Introducing SPOTVOL and LTV
### SPOTVOL: A Real-Time Volatility Snapshot
SPOTVOL estimates the instantaneous (or spot) volatility level of the S&P 500 Index itself, based on a model-free approach using real-time index prices. Unlike the VIX, which is based on option prices and implied volatility, SPOTVOL measures actual realized volatility inferred from current spot price movements, providing a "nowcast" rather than a forecast.
### LTV: Focusing on Extreme Downside Risk
LTV focuses specifically on the left tail of the S&P 500 return distribution, essentially quantifying the market’s expectation of extreme downside risk or large negative moves. While the VIX measures overall expected volatility (both upside and downside), the LTV isolates downside tail risk, which is particularly relevant for risk-averse investors concerned about market crashes or sharp declines.
## The Differences and Benefits of SPOTVOL and LTV
1. **More Granular Information:** SPOTVOL and LTV provide more detailed insights into market volatility and risk, separating out upside and downside risk, and focusing on real-time and extreme downside risk, respectively.
2. **Better Risk Management:** By understanding the left-tail risk (LTV) and the current volatility state (SPOTVOL), investors can make more informed decisions about hedging strategies and portfolio adjustments.
3. **Complementary to VIX:** SPOTVOL and LTV complement the VIX rather than replace it, offering a more comprehensive view of market risk.
4. **More Relevant to Different Investment Strategies:** Traders focused on volatility arbitrage, tail-risk hedging, or real-time adjustment of portfolios find these indices more actionable.
## The Role of SPOTVOL and LTV in Market Conditions
On March 6, 2020, after Russia rejected OPEC's demand to curb oil production, LTV showed a dramatic increase, while VIX and SPOTVOL responded moderately. This response suggests that LTV could serve as an effective early indicator of turbulent market conditions, particularly extreme downside risk.
On Feb 5, 2018, the VIX index jumped 116 percent due to sudden investor fear of rising inflation and an uncertain economy. In this case, LTV might have served as a more accurate predictor of the turbulent market conditions that followed, given its focus on extreme downside risk.
## In Conclusion
While the VIX remains an essential tool for measuring overall market volatility, SPOTVOL and LTV offer investors more nuanced, timely, and actionable information about volatility and risk. SPOTVOL is useful for investors who want to optimize their market entry and exit points and for those wishing to protect their portfolio from day-to-day market fluctuations. Investors can use LTV to help them decide when to hedge against extreme tail events, perhaps by moving to safer assets or those that would profit from sharp declines in the market.
Andersen and Todorov, the professors who developed these indices, hope that SPOTVOL and LTV become as popular as the VIX index. As more investors become aware of these powerful tools, they may find themselves better equipped to navigate the complex and ever-changing financial markets.
- The emergence of the Cboe S&P 500 Spot Volatility Index (SPOTVOL) and the Cboe S&P 500 Left Tail Volatility Index (LTV) in the financial markets signifies an opportunity for sophisticated investors to utilize technology in their investment and risk management strategies, as these indices provide a more granular understanding of market volatility and risk.
- In comparison to the VIX, which measures overall expected volatility, SPOTVOL offers a real-time snapshot of the S&P 500 Index's volatility level, while LTV focuses on extreme downside risk, potentially serving as an effective early indicator of turbulent market conditions.
