Implied Volatility Indices as Leading Indicators of Stock Index Returns?

Abstract

This paper shows that, when the VIX or VXN indices of implied volatility increase, the S&P100 and NASDAQ100 stock indices exhibit on average negative returns, hence the 'fear factor' associated with high levels of implied volatility in financial markets. However, attractive (from a mean-variance perspective) positive returns should then be expected on average in the immediate short-term. In this framework, very high levels of implied volatility can on a statistical basis be viewed as signalling an imminent increase in stock indices, at least on a short term basis. Our analysis also shows that average to moderately high levels of implied volatility lead to unfavorable (from a mean-variance perspective) returns. Thus traders willing to enter 'oversold' markets should wait until extremely high levels of implied volatility are witnessed, and their strategy should be strictly on a short-term basis.

Keywords: Implied volatility, VIX index, trading, return and risk