How You Can Utilize Stock Market Volatility

by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
July 31, 2009

Key points

Based on S&P 500 option prices, the VIX is a measure of expected market volatility.
Learn about distinct patterns among various market indexes, depending on whether the VIX was high or low.
Action steps: Using VIX in your stock strategy.

Mark Twain once quipped, "Everyone talks about the weather, but nobody does anything about it!" So it seems to be with stock market volatility—the degree to which stock prices fluctuate. Since 2007, there's been a lot of talk about high volatility, but the message to investors has been to get used to it, or wait it out.

While patience is generally a virtue for investors, Schwab research suggests that, indeed, stock investors who like to make tactical shifts in their portfolios can utilize market volatility to help boost returns and manage risk.

Measuring stock market volatility
Market volatility measures recent price changes for broad indexes like the S&P 500®. But while actual volatility tells you what's already happened, investors must look ahead, so what they need is a way to gauge potential future volatility.

Fortunately, the Chicago Board Options Exchange (CBOE) provides a convenient tool: the Volatility Index, or VIX. Based on S&P 500 option prices, the VIX is a measure of expected market volatility.

VIX history
First, let's take a look at how the VIX has behaved in the past. The chart below shows that it's generally ranged between 10 and 30 during the past 20 years, occasionally surging higher.

Because the VIX usually rises when the market falls and spikes during times of market distress, it's often called the "fear index." However, the VIX is really an uncertainty index, reflecting actual prices paid and demanded by bullish and bearish options traders.

Chart: Stock Volatility

Volatility tends to persist
Wouldn't it be great to know when the stock market was in a high- or low-volatility period, and adjust your equity strategy accordingly? The challenge comes in predicting volatilty persistence or shifts with enough accuracy to profitably act upon your forecast.

The chart shows two periods when the VIX was generally below its long-term average and two where it was generally above the average.

We found that when the VIX was above 20, 78% of the time it remained above 20 three months later. When it was below 20, 85% of the time it remained below 20 three months later. So the VIX has historically tended to remain high or low for extended periods.

Stock performance during high or low volatility
So if the VIX tends to rise as the stock market falls, what happens to the market after the VIX moves above or below its long-term average? Our research found distinct patterns among various market indexes, depending on whether the VIX was high or low.

Large- and small-cap stocks¹ generally provided higher returns (about 2.6% each) the quarter after the VIX fell below 20 versus the quarter after it rose above 20 (1.5% and 2.4%, respectively).
Large- and small-cap returns were almost 50% less volatile in periods after the VIX fell below 20 compared to after it rose above 20. In other words, the VIX has predicted market volatility well.
Value stocks significantly outperformed growth stocks (3.1% large-cap value versus 2.1% large-cap growth and 3.3% small-cap value versus 1.9% small-cap growth) in periods after the VIX slipped below 20. Large-cap growth outperformed large-cap value (1.7% versus 1.1%) in periods after the VIX rose above 20.

Action steps: Using VIX in your stock strategy
Our findings suggest that investors can benefit from keeping an eye on the VIX (keeping in mind there's no guarantee future patterns will duplicate the past).

For example:

If you're a buy-and-hold investor, you can use the VIX to help decide when to rebalance. For example, if your portfolio is overweighted in stocks and the VIX is above 20, consider selling back to your target stock allocation. When the VIX is high, the market is usually riskier and provides below-average returns.
When the VIX is low, you may want to overweight large-cap and/or value stocks within your equity allocation. When the VIX is high, you may wish to underweight stocks overall, but overweight small-cap or growth stocks within your equity allocation.
If you buy individual stocks, you don't need to vary your strategy as much in response to VIX levels, but you should expect less consistent performance when the VIX is high. When it's low, using value and momentum selection criteria may help performance. Schwab Equity Ratings, our tool to help you find individual stocks, has historically performed similarly when the VIX is low or high.

History suggests that market returns will remain volatile in the near future and that small-caps may continue to outperform large-caps.

1. Large-cap stocks are represented by the Russell 1000® Index; small-cap stocks are represented by the Russell 2000® Index.

Important Disclosures

Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, and the Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The indexes are not investment products available for purchase.

The S&P 500® index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Historically, small-cap stocks have been more volatile than the stocks of larger, more established companies.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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