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Relative value of large cap volatility.

We all track the VIX as a measure of volatility, but we often forget that the VIX is volatility indicator for the large cap index within the SP500. We can construct volatility measures of volatility for different sectors/industries (tech, healthcare, financial, etc.). There is volatility on size mid-cap indices, small cap.

One thing that caught my eye the other day was the volatility on the Russell 2000, which is the volatility on the small cap indices and which is currently trading at 20, is about 8 points higher than volatility on the VIX, the large cap volatility index. Historically, the VIX has always been 70% of the RVX.

Looking at a historical chart of the ratio of VIX:RVX I saw that the ratio tended to increase in major market corrections and tended to approach parity before reversing around. Besides the fact this indicator could be used for market timing, I would like to get many of your takes as to why the volatility expectations on large cap stocks increases faster and reaches the same level as that of small caps. How?? It is clear that small cap stocks are riskier, have a higher beta and are less capitalized than larger firms. This relationship I have described was not a one time instance, it has repeated many times and therefore worth noting here. I appreciate all your feedback.

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Cross-posted here: wilmott.com/messageview.cfm?catid=38&threadid=96826 –  vonjd May 19 at 19:12
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It seems like the explanations on the link @vonjd provided cover the sort of basic explanation (financial crisis). What else are you looking for? –  John May 19 at 21:46

2 Answers 2

Could it be a result of the fact that stocks get stickier as the market cap decreases? Once the 2008/2009 exploded liquidity dried up in the small and micro-cap arena and bid/ask spreads prevented any trading. This is also a consequence of the fact that in the small-micro-mid cap a larger share of the players have a buy-and-hold style.

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It's a good question. I'll try to brainstorm for other factors. –  pincopallino May 21 at 12:45
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Interesting theory selfTight. So your argument is in massive market drop liquidity recedes faster for the small caps than the large caps. Yes it does prevent lower volume of trades but wouldn't the options sellers on the small caps then have better pricing power?? Since liquiduity is dry, the seller is passing that cost to the buyer, would'nt that drive the premiums up? –  jessica May 24 at 2:44
    
We should have a look at how the vol indices are calculated. Vol indices (see vix here: cboe.com/micro/vix/vixwhite.pdf) are built taking mid-point prices and they strips out missing bid or ask quotes as well as points of the term structure within missing bid or ask quotes. This means that are able to capture volatility resulting from more active trading (ups and downs) but can't model well impact of dry liquidity. –  pincopallino May 27 at 13:20

\$VIX and \$RVX strongly correlated with market action. Therefore, I agree with @SelfTaght line of reasoning to find the differentiating factor. this paper provides some additional information - "Call purchases increase with positive returns and decrease on days with negative returns, while put purchases behave exactly the opposite way. However,both call and put sales increase on days with large positive or negative returns." Leveraged portfolio also add to the decline (sell pressure) due to margin requirements or day trading rules etc. However, The small or micro cap stocks do not benefit from buy and hold. Warren Buffet types, pension funds hold big names, big caps, partly mandated by their charter, which typically have lower volatility. That is why \$RVX is generally larger than \$VIX.

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just looking at where the VIX is compared to RVX, something is so weird now. The ratio came down from both sides, the numerator, the VIX actually came down and from the denominator, the RVX has had a slight bump up. Volatility on the VIX looks EXTREMELY cheap right now. Bad time to sell on the SPX IMO. –  jessica May 24 at 2:39
    
Not a good time to sell VIX or SPX. Charts show RVX came down even more - the ratio you are looking at went up. Should not sell SPX unless you are buying RUT or you could buy RUT and SPX, both. SPX is near the tops , RUT near the bottom of correction. Beware, VIX behavior changes over time, it goes up when index is going up due to fear that it will fall. If you own SPX then buy some puts or buy OTM strangle, later. Your indicator is hopefully just one tool in your toolbox. –  user12348 May 24 at 4:36
    
I have never seen this kind of behavior in the markets ever. Usually as your getting a correction the VIX generally spikes, were not seeing that here. VIX is making all time lows. I know this bull market isn't over, the econ/earnigns data is still strong, but I fear a one-time, 5%-6%, swoop drop that shakes longs and causes option traders to reprice volatility in line with reality. –  jessica May 25 at 2:19

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