Forecasting volatility and market returns using the CBOE Volatility Index and its options

This study examines the Chicago Board Option Exchange Volatility Index (VIX) and its options. The VIX is the implied volatility calculated from short-term option prices on the Standard & Poor’s 500 (S&P 500) stock index. Our findings demonstrate that VIX overestimates average volatility by approximately 3% but explains 55% of the S&P 500’s following month’s volatility and 20% of its return. The smirks calculated from the VIX options’ implied volatility add additional explanatory power for the S&P 500 returns. None of the variables help predict skewness or kurtosis values (a measure of tail risk). A simple trading rule that buys the S&P 500 when the VIX, the implied volatility from the options on the VIX and the VIX options’ volatility smirk all decline is associated with an in average monthly return of 1.96% in the S&P 500 relative to its 0.84% average. This only occurs approximately 10% of the time and would not beat a buy-and-hold strategy, but it could be used to adjust asset allocations at the margin. Buying equities only when the VIX decreases, which occurs approximately 50% of the time, outperforms a similar 50/50 stock/bond risk portfolio.