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.

I suppose you are looking at the 2008/09 crash ? I think in that instance a large part of the jump in VIX volatility was due to the financial sector where those stocks were effectively bust (AIG/C/ML/BAC/AIG/GS/WACHOVIA etc). Another thought is that there is a "limit" to the volatility level of stocks - so when things crash they all approach this "limit".

QuoteOriginally posted by: amandathepandaRelative 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.It could be a risk-on/risk-off effect. The reasoning would be that in 'normal' market conditions people tend to make risk-on type bets, i.e. small cap, EM etc... However when conditions deteriorate, they all rush to risk-off positions. Typically one place this haven would be is in certain large cap names. This might increase the volatility in those names. You would need to dig into the data to see if this makes sense. As daveangel says, it may also be that when there is a crash, people rush away from expensive looking large caps (particularly if momentum is expensive). This can cause large rapid changes in the price of these stocks at a time when they are major constituents of the index. The reason that it approaches parity could simply be that once the large cap space gets that disrupted, the haven money simply goes elsewhere. Similarly if you are rotating out of 'risky' equities into non risky equities, you will only do so as long as the non-risky equities actually look non-risky. Your axiom " It is clear that small cap stocks are riskier, have a higher beta and are less capitalized than larger firms" only applies to certain firms in normal market conditions all else being equal. It is not a law of the universe and at a time of crisis things can get weird.. or not: it is also times of crisis where you might find that those big solid 'well capitalised' companies that everyone has bid-up are actually a lot more shaky than the market appreciated.As for using it as an 'indicator': Finding a relationship in an aggregate historical statistic is one thing. Making implementable trades in the right instruments is quite another. I dont think you are the only one in the market who would examine volatilities as a signal. Interesting observation though.

If you look at a longer history of recessions, I think you'll find that, in general, small caps are hurt more than large caps(say from market peak to trough). So, perhaps one shouldn't generalize too much from the last one ...

I would love to post a picture here of the two ratio between the VIX/RVX. But the attachment option won't accept the image file, it says something along the lines of "Sorry but the file your attaching is not permitted". What am I doing wrong??

dunno about attaching picturesHowever, if you regress VIX vs RVX you should get a beta of 0.92 with a correlation of 0.98. the ratio of VIX to RVX is almost always < 1 except for 2008 when it reached 1.per my Bloomberg

To include a picture:(1) Upload your .jpg file to a public web site for picture storage, such as tinypic.com. You will receive a URL for your picture, write it down.(2) On Wilmott click on the image icon (a frame with a view of Mount Fujii), when prompted for the link, enter the URL received previously

Thank you!

Not sure if the image uploaded:http://tinypic.com/view.php?pic=24pghus ... 3wUYfldX5k

Precisly, which justifies the argument that the volatility on the large caps, the vix, should never trade or reach parity when sell offs happen.

QuoteOriginally posted by: amandathepandaPrecisly, which justifies the argument that the volatility on the large caps, the vix, should never trade or reach parity when sell offs happen.over the history that I looked at this has only happened once in 2008/9 financial crisis. I suppose the explanation here is the same as the one I proposed before which is that most of the increase in VIX vol was due to the financial sector. I wouldn't want to make such definitive statements such as "the vix should never trader or reach parity" (I guess you mean parity with RVX). Looking back at your original question, I thought you made an interesting observation about the rate at which vols of large cap stocks change when compared to the RVX. If you do a regression of the percent change in VIX versus the percent change in RVX this can be seen clearly - the volatility of the VIX is higher than the volatility of RVX. the correlation of the %age changes is around 95%. One argument that can be is that large cap equities have a greater sensitivity to the "leverage" effect.

I am speculating here, but I think the effect you describe might be related to the fact that volatility skew of SPX is steeper than the skew of Russel 2000. Think about ATM vol as a proxy for VIX; as the underlying price moves around, ATM vol will more or less ride the skew - if it is steeper the change of ATM vol will be larger. The difference in slopes could in turn be due to higher correlation among components of SPX; on average they are more dependent on the state of the economy vs. various idiosyncratic factors.

QuoteOriginally posted by: daveangeldunno about attaching picturesHowever, if you regress VIX vs RVX you should get a beta of 0.92 with a correlation of 0.98. the ratio of VIX to RVX is almost always < 1 except for 2008 when it reached 1.per my BloombergDave, Would you mind sharing how you calculated the beta for the VIX RVX pair? I got something very different from your result. Thanks