Implied Volatility Measures As Indicators of Future Market Returns

Abstract

We analyze the relationship between implied volatility and subsequent equity markets excess returns. We find that high readings of implied volatility have a strong correlation with positive and economically sizable returns in the subsequent 1, 5, and 20 trading days. Mid-level readings are generally associated with returns which are statistically positive but not economically significant. Low readings show a statistically meaningful link with negative but economically small returns. We also document that the statistical relationship with equity markets behavior is stronger when using the VIX as a measure of implied volatility instead of the implied volatility of at-the-money straddles.

Keywords: VIX, volatility, market returns, IV

JEL Classification: C1, G1