For a long time, the VIX index is recognized as a measure
of implied options contracts and is supposed to provide an expectation into what the market will act over the next 30 days. However, data tells a different answer: VIX return does have good explanation power to current market return, but it has an almost-zero relationship with future market return. The following figure shows this phenomenon.
This characteristic makes the VIX index a coincident indicator than a leading one and fails our smoothing schemes. Thus, finding a new way to inform earlier becomes a crucial issue. From our group’s work, VIX spread gives good potential to detect future market changes.
Due to the VIX spread having ten times higher volatility than the market, smoothing is a reasonable way to reduce noise, but the smoothed line should keep its forward-looking ability. The result below shows the explanation power of the original spread and smoothed spread by R_squared value.
Both lines show prediction power to future market volatility. In the future, applying these results to generate market expectations and connect to market returns will be our next step.
AVP Quantitative Finance, Gamma Paradigm
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