## Volatility cycles and stock trends

### VSTOXX

In the “monkey-see, monkey-do” world of financial markets, the SX5E and VSTOXX occupy the same niche as the S&P 500, the VIX and associated derivatives. Like VIX futures, VSTOXX futures can be added to STOXX-related investments to reduce overall portfolio volatility. Some think this is superior to either selling the stocks outright or buying put options outright. Complexity is the flame for assorted financial moths.

We can look at the VSTOXX/SX5E relationship several different ways. First, let’s map the daily high-low range of the VSTOXX against the SX5E over the available data sample starting in April 2005; this measure takes time out of the equation (see “Shock & regress,” below).

Not only is the expected inverse relationship visible, so is the pattern of expanding volatility ranges at the lower price range of each cluster. The volatility of volatility increases as prices decline. The VSTOXX’s high/low range for two days in late 2014, the Oct. 16 panic low and the Dec. 5 reaction high, are marked.

VSTOXX futures’ pseudo-forward curve have predictable rhythms, too (see “Trend response,” below). The “pseudo” adjective is added as assets are not carried forward by these futures; instead, each month settles into what effectively is the fixed leg of a variance swap. As a result, a market selloff tends to elevate the spot VSTOXX, marked in green, more than the first month of the futures and so on. With time, market rallies have the opposite effect of lower the spot VSTOXX, relative to each successive month of the futures contract. This is visible on the closing forward curves for VSTOXX futures on the two dates noted.

Let’s construct a measure of excess volatility by comparing the ratio of the SX5E’s implied volatility to its high-low-close volatility and subtracting

1.00 therefrom.

High-low-close volatility incorporates the effects of intraday range as well as interday change, and tends to decline during prolonged directional moves and to expand during sideways and transitional markets. Because implied volatility is forward-looking (or is at least alleged to be) and because HLC volatility is a historic measure, the excess volatility measure gives us a sense of when option buyers are willing to pay more for price insurance.

The answer, somewhat surprisingly, is that option buyers pay up more relative to historic volatility during the early phase of a downturn than during a full-blown selloff. However, the absolute level of the VSTOXX increases with the depth of the selloff (see “Excess volatility,” below).