Something you may hear us mention from time to time here at Option Pit …
(Especially if you attend live events …
Speaking of, you’re registered to join Griff on Tuesday, right?!)
… Are volatility “zones.”
We’ve classified volatility into four “zones,” and knowing these zones can tell us important things about what to expect out of the markets.
You can use the zones to categorize both realized volatility (RV) and implied volatility (IV), but today I’m going to mostly focus on the zones of the VIX (implied volatility).
Realized vol and implied vol can be in different zones at different times. Realized volatility is the movement the market has seen or is currently seeing, while implied volatility is movement that the market is anticipating.
Therefore, even in times of low realized vol, you can have much higher implied vol (and vice versa).
Here are the four zones, and what they represent.
Zone 1 represents ultra-low volatility, and this zone is actually more common than you might think. While the long-term average of the VIX tends to be between 18-20, there are more occurrences of the VIX at 12 than any other integer.
Typically, a VIX at 14 or lower is in zone 1. It might be hard to believe right now, but the VIX is actually in zone 1 more than 25% of the time, and zone 1 is the most common zone for realized volatility.
We haven’t seen zone 1 for a long time, but just to refresh your memory, we did see it quite a bit before the COVID meltdown in 2020, such as in summer of 2019:
Often we will see implied volatility lead realized volatility both in and out of zone 1.
In other words, IV will drop into zone 1 before realized volatility drops into zone 1, and IV will also tend to pop out of zone 1 before realized volatility does. This is NOT true in all zones, however.
We can also expect to see the market trending higher during zone 1 – which makes sense when you think about the fact that the VIX and S&P 500 (Ticker: SPX) tend to have an inverse correlation (when one goes up, the other goes down).
You can think of zone 2 as more “normal vol” – it usually represents a VIX between 14-18.
(This is where we are right now.)
During zone 2, the market behaves pretty normally. We’ll usually see the market going higher, with small periods of vol, especially ahead of events like Fed meetings, nonfarm payrolls, and midterm elections, and so on. (Sound familiar?)
This is the most common zone for implied volatility. While RV hangs around in zone 1 more often than any other zone, it actually takes quite a while for the VIX to hit zone 1. This shouldn’t be too surprising – after all, just consider how traders price in higher implied volatility into options to make up for uncertainty. Uncertainty, and hedging against uncertainty, also drives up IV (and the VIX).
A zone 3 VIX is in the 18 to 23 range, and this usually indicates that there is at least one macro event that is causing traders to worry.
For example, look at the VIX pop in October 2019, on concerns about U.S./China relations:
Traders are worried … but haven’t quite hit the “panic” zone just yet. Unlike zones 1 and 2, where IV and RV can move separately, once realized vol hits zone 3 (so when we are seeing multiple daily 1% moves) IV is quick to follow, and IV can also lead RV into zone 3.
Zone 3 can happen in a bull market, but it is typically short-lived. An extended move into zone 3 often indicates that we are in, or headed for, a bear market.
Either way, you can think of zone 3 as a “transition zone” – the market is either about to enter the “panic territory” of zone 4, or move back down into the calmer waters of zone 2.
In zone 4, we expect to see the VIX over 24, and this is when the market is really panicking.
The COVID crisis is a great, albeit extreme, example of a zone 4 VIX:
Unlike zone 3, the VIX moving into zone 4 is almost always reactionary to the market’s realized volatility popping into zone 4 first.
And once the VIX hits zone 4, it tends to be slower to calm down than realized volatility – think about how slowly the VIX came down after the COVID crisis, even though the markets only really dropped for a short while.
Even after the markets recovered and resumed their string of all-time highs, the VIX, while it did come down from its huge COVID peak, remained above 24 for quite a while longer.
Here the SPX is the top graph, while the VIX is the bottom. Notice how even into 2021, the VIX has not returned to its pre-COVID levels:
So why are these zones important?
Well, knowing which zone the VIX is currently in can help us predict market activity.
During zone 1, with low vol, we can usually assume a bull market.
Meanwhile, in zone 4, we would want to brace for a pretty drastic pullback.
The above graphs of the VIX and SPX during the COVID crisis are a pretty good illustration of how the SPX and VIX tend to move in opposite directions – and how we can use vol zones to infer how the market is going to behave.
Knowing which zone volatility is in can also clue us into trader sentiment.
Are people expecting a big macro event to shake things up?
Or are we mostly looking at smooth sailing?
A VIX spike from 14 to 17 might sound like a big move …
But when you look at it in terms of VIX zones, it doesn’t seem quite so disastrous.
Knowing the zones of vol, and how vol tends to behave in each zone, can be a great way to make sure you are trading and hedging appropriately.
Your Only Option,