Question

Some investors believe the VIX follows a mean-reversion process. Do you agree? Why? (Please proof your answer based on VIX returns from Jan. 02, 2000 to Apr. 25, 2020)

Answer 1

Please mentioned below the answer

Mean reversion is a theory used in finance that suggests that asset prices and historical returns eventually will revert to the long-run mean or average level of the entire dataset. This mean can pertain to another relevant average, such as economic growth or the average return of an industry.

This theory has led to many investing strategies that involve the purchase or sale of stocks or other securities whose recent performances have differed greatly from their historical averages. However, a change in returns also could be a sign that a company no longer has the same prospects it once did, in which case it is less likely that mean reversion would occur.

Percentage returns and prices are not the only measures considered in mean reverting; interest rates or even the price-earnings (P/E) ratio of a company can be subject to this phenomenon.

A reversion to the mean involves retracing any condition back to a previous state. In cases of mean reversion, the thought is that any price that strays far from the long-term norm will again return, reverting to its understood state. The theory is focused on the reversion of only relatively extreme changes, as normal growth or other fluctuations are an expected part of the paradigm.

KEY TAKEAWAYS

• Mean reversion in finance suggests that asset prices and historical returns eventually revert to their long-term mean or average levels.
• The mean reversion theory has led to many investment strategies from stock trading to options pricing.
• Mean reversion trading tries to capitalize on extreme changes in the price of a particular security, assuming that it will revert to its previous state.

The mean reversion of the VIX- the speed at which it returns to its long run average, is faster than it’s ever been. This implies that while the VIX is at historically low levels, any news shocks that cause the VIX to jump will fade out extremely quickly. Traders should not get spooked by spikes in the VIX. A fleeting investor is likely to miss out on a large upside.

Mean reversion is a financial term for the assumption that a stock's price will tend to move to the average price over time.

Using mean reversion in stock price analysis involves both identifying the trading range for a stock and computing the average price using analytical techniques taking into account considerations such as earnings, etc.

When the current market price is less than the average price, the stock is considered attractive for purchase, with the expectation that the price will rise. When the current market price is above the average price, the market price is expected to fall. In other words, deviations from the average price are expected to revert to the average. This knowledge serves as the cornerstone of multiple trading strategies.

Stock reporting services commonly offer moving averages for periods such as 50 and 100 days. While reporting services provide the averages, identifying the high and low prices for the study period is still necessary.

Mean reversion has the appearance of a more scientific method of choosing stock buy and sell points than charting, because precise numerical values are derived from historical data to identify the buy/sell values, rather than trying to interpret price movements using charts (charting, also known as technical analysis).

Some asset classes, such as exchange rates, are observed to be mean reverting; however, this process may last for years and thus is not of value to a short-term investor.

Mean reversion should demonstrate a form of symmetry since a stock may be above its historical average approximately as often as below.

A historical mean reversion model will not fully incorporate the actual behavior of a security's price. For example, new information may become available that permanently affects the long-term valuation of an underlying stock. In the case of bankruptcy, it may cease to trade completely and never recover to its former historical average.

In finance, the term "mean reversion" has a different meaning than "return or regression to the mean" in statistics. Jeremy Siegel uses the term "return to the mean" to describe a general principle, a financial time series in which "returns can be very unstable in the short run but very stable in the long run." Quantitatively, it is the standard deviation of average annual returns that declines faster than the inverse of the holding period, implying that the process is not a random walk, but that periods of lower returns are then followed by compensating periods of higher returns, for example in seasonal businesses.

VIX is the ticker symbol and the popular name for the Chicago Board Options Exchange's CBOE Volatility Index, a popular measure of the stock market's expectation of volatility based on S&P 500 index options. It is calculated and disseminated on a real-time basis by the CBOE, and is often referred to as the fear index or fear gauge.

The VIX Index is a volatility index derived from S&P 500 options, with the price of each option representing the market's expectation of 30-day forward-looking volatility. The resulting VIX index formulation provides a measure of expected market volatility on which expectations of further stock market volatility in the near future might be based. Like conventional indexes, the VIX Index calculation employs rules for selecting component options and a formula to calculate index values. Unlike other market products, VIX cannot be bought or sold directly.[4] Instead, VIX is traded and exchanged via derivative contracts (Futures contract, Option (finance)), or derived Exchange-traded fund (ETFs), and exchange-traded notes (ETNs) which most commonly track VIX futures indexes.

When the market goes down, investors would want to purchase insurance, which drives up the prices of put options and increases the VIX. The VIX decreases when there's less demand for put options as the market rises. That's why it tends to move inversely to equities. Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely

Today, it has fallen significantly to about 30 basis points. There are several options to trade the VIX. The simplest approach is to buy Exchange Traded Notes (ETN) or Exchange Traded Funds (ETF) on the index. The largest vehicle is the iPath S&P 500 VIX Short-Term Futures ETN (VXX).