Is the VOLQ Volatility Index a Sentiment Indicator?

With the recent decline in equity prices, now is a good time to review some behavioral aspects of the Nasdaq 100 index (NDX) and its relationship with the VOLQ volatility index.

Introduction:

As Fig. 1 notes, “bear market” related articles currently is the highest story count since March 2020. This data suggests discussions of downside volatility and related topics tend to increase during stock market corrections. Downside volatility refers to volatility when a market declines in value.

January 24, 2022, observed 1,389 “bear market” related articles versus 186 articles on November 9, 2021. The median story count during the period in Fig. 1 is 168. Not all bear market-related articles discuss equities. However, when equities decline the story count tends to increase.

If articles are increasing the public discussion of market selling during market turning points, is this a reflection of market sentiment? Could volatility be a sentiment indicator? We’ll discuss this later in the article.

Fig. 1: 2/10/2020 to 1/28/2022 News trend of “bear market” articles vs NDX

Bear market story count

Source: Bloomberg

November 19, 2021, the NDX peaked at a close of 16,573.34 as it traded sideways for the remainder of the year. With a new year, came a new equity correction as NDX experienced a drawdown of 15.51% as the index declined from the November 192021 closing price to the January 27, 2022 closing price.

A drawdown is generally defined as a value decline from a peak to a trough.[i] The current drawdown is the largest since the NDX decline of -28% during the Feb/March 2020 COVID-related decline.

VOLQ

Each time NDX declines, it is often accompanied by a VOLQ volatility index rally as the two indices tend to be negatively correlated. From January 31, 2019, to Jan 28, 2022, the correlation of the two indices is -0.77.

NDX is the underlying market of the VOLQ volatility index that calculates 30-day implied volatility. The index is priced as an annualized standard deviation. For example, a price of 15 equals a 15% annualized standard deviation. This can be interpreted as higher VOLQ pricing equates to larger drawdowns as observed in Fig. 2.

The VOLQ index pricing is derived from NDX option prices. From my years of researching and writing about volatility indices, I’ve found they may offer some insight into the perspective of the underlying options participants. For example, if VOLQ pricing increases, NDX is probably declining or at least in a trading range implying the market’s sentiment of risk and/or uncertainty is increasing. This increased uncertainty is often expressed in option pricing. Thus VOLQ could be utilized as a market sentiment indicator.

If the VOLQ index trades along the bottom of its price range, it suggests NDX is trending higher. If the volatility remains low for extended periods, the “Compressed Spring Effect” as I call it may occur. When VOLQ moves higher, it implies NDX is declining as noted in Fig 2.

The data in Fig. 2 demonstrates the VOLQ index frequently spikes as NDX declines, but the volatility index may gradually move lower over days, weeks, or months. From the close of March 16, 2020 VOLQ price peaked at 78.13, it bottomed at 14.30 on August 27, 2021.

Fig. 2 NDX & VOLQ Daily Closing Prices 1/31/19 to 1/28/22

NDX and VOLQ daily closing price

Source: Bloomberg

The recent 15% drawdown is a little larger than some of the recent declines, but not unusual. One could argue, NDX is currently in a correction phase. A decline of 20% or more is often considered a bear market.[ii]

On January 25th the VOLQ index closed at 34.15, the highest close since 36.98 on November 2, 2020, suggesting increasing market nervousness. Some of the current factors potentially influencing the market may include, a possible Russian invasion of Ukraine, continuing inflation, and the Federal Reserve implying rate increases in 2022.

From January 31, 2019, to January 28, 2022, the VOLQ closing prices tend to trade at a low range of 10 to 14 with a median price of 20.23 and a resistance around the low to mid-20s. VOLQ may offer insight into market sentiment. It can also be used for directional trading and hedging via VOLQ futures.[ii]

Correlation:

Fig. 3 Regression of NDX to VOLQ Returns 1/31/19 to 1/28/22

Negative correlation of NDX to VOLQ

Source: Bloomberg

Fig. 3 shows the returns of NDX on the X (horizontal) axis and the VOLQ index returns on the Y (vertical) axis. The regression data suggests a negative correlation. For example, in the lower right quadrant NDX has positive returns, VOLQ’s returns tend to be negative. In the upper left quadrant when NDX is negative, VOLQ tends to be positive. Over the entire period, the correlation is -0.77. The orange fitted line represents a predicted line of how VOLQ may behave directionally relative to the performance of NDX.

Summary:

Volatility indices tend to have two major components; 1) it tends to be a range-bound product, hence mean-reverting, so the bottom and top prices of the ranges are generally known. On occasion they will exceed the bottom and top ranges. 2) It’s difficult to determine when it will rally, but when it does, it often moves quickly, as in the current situation. After the price peak, it may gradually move lower for days, weeks, and sometimes months. As a range-bound index, conceptually you could think of it as similar to trading a spread. The VOLQ volatility index may offer sentiment insight of the NDX option participants.

[i]https://www.investopedia.com/terms/d/drawdown.asp

[ii]https://www.investor.gov/introduction-investing/investing-basics/glossary/bear-market

[ii]https://www.cmegroup.com/trading/equity-index/us-index/volq.html

Past performance is not necessarily indicative of future results. There is risk of loss when investing. Only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

https://www.nasdaq.com/articles/is-the-volq-volatility-index-a-sentiment-indicator

Jinggo B Danuarta

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