Lesson 6: Vol Regimes

Promise: Learn to identify high-vol vs low-vol environments, understand why volatility clusters, and recognize regime changes.

What is a Vol Regime?

A vol regime is a persistent market state defined by volatility characteristics. Markets don't randomly bounce between 20% and 80% vol. They tend to stay in one mode for a while, then shift.

Regime

BTC IV Range

Characteristics

Duration

Low Vol

30-45%

Range-bound, grinding, "boring"

Weeks to months

Normal Vol

45-65%

Healthy trends, moderate swings

Typical state

High Vol

65-90%

Fast moves, elevated fear

Days to weeks

Crisis Vol

90%+

Panic, capitulation, gaps

Days

💡

Vol doesn't move randomly. It clusters in regimes and mean-reverts slowly.

The Key Pattern: Volatility Clusters

One of the most robust findings in finance: high volatility days tend to follow high volatility days. Low follows low. This is called volatility clustering or persistence.

Volatility Clustering

The pattern: Vol spikes fast but decays slowly. High-vol days cluster together, and so do low-vol days. This is volatility persistence.

Why does this happen?

• Information cascades: Bad news begets more bad news. Fear feeds fear.
• Leverage effects: When prices drop, leverage ratios increase, increasing future vol
• Behavioral: Panic doesn't end in one day. Neither does complacency.
• Market structure: Margin calls and liquidations create feedback loops

Quantitative models capture clustering using GARCH (Generalized Autoregressive Conditional Heteroskedasticity):

$$\sigma^2_t = \omega + \alpha \epsilon^2_{t-1} + \beta \sigma^2_{t-1}$$

In plain English: Tomorrow's volatility depends on:

• A baseline level ($\omega$)
• Today's surprise move ($\alpha \epsilon^2_{t-1}$) - big surprises increase tomorrow's vol
• Today's volatility ($\beta \sigma^2_{t-1}$) - high vol persists

The $\alpha + \beta$ term determines persistence. Values close to 1 (like 0.97) mean vol shocks take a long time to decay.

Practical implication: After a vol spike, don't assume instant normalization. Plan for elevated vol to persist for days or weeks.

Mean Reversion: Vol Eventually Normalizes

Despite clustering, vol eventually reverts to a long-term average. Extreme readings don't persist forever.

The pattern:

• High vol → market expects it to come down (hence contango often appears after spikes)
• Low vol → market expects it to rise eventually (hence mild backwardation can emerge)

This creates a natural pull toward "normal" levels over time.

Volatility Mean Reversion

Start at:

The pattern: Starting at 80% (above average), vol is expected to decay toward 50%. This creates backwardation in the term structure - near-term IV is higher than far-term.

Current Vol: 80%

A simple mean-reverting vol model:

$$\sigma(T) = \sigma_\infty + (\sigma_0 - \sigma_\infty)e^{-\kappa T}$$

Where:

• $\sigma_\infty$ = Long-term average vol (where vol "wants" to be)
• $\sigma_0$ = Current vol
• $\kappa$ = Mean reversion speed

If current vol (80%) is above long-term (50%), the term structure will slope down - far-term options will be cheaper than near-term.

Identifying the Current Regime

1. IV Level vs History

Where is ATM IV relative to its historical range?

Percentile	Interpretation
Below 20th	Low vol regime - options are cheap
20th-80th	Normal range
Above 80th	High vol regime - options are expensive

2. IV vs Realized Vol

Compare implied vol to recent realized volatility:

Comparison	Interpretation
IV >> RV	Options expensive. Market expects vol to increase (or is overpaying)
IV << RV	Options cheap. Market expects vol to decrease
IV ≈ RV	Fairly priced. No strong view

3. Term Structure Shape

• Backwardation (near > far): Market expects current high vol to subside
• Contango (far > near): Market expects vol to pick up later

4. Vol Index Levels

Check DVOL (Deribit's BTC vol index) or VIX (for equities):

DVOL Level	Interpretation
< 45%	Low vol (for crypto)
45-65%	Normal
65-85%	Elevated
> 85%	High fear/excitement
> 100%	Crisis

Regime Transitions

Low → High Vol Transition

Usually sudden. Triggers include:

• Unexpected news (hacks, regulatory, macro)
• Technical breakdowns (support breaks)
• Liquidation cascades

Warning signs:

• Vol term structure inverting
• Skew steepening
• Spot breaking key levels

High → Low Vol Transition

Usually gradual. The market calms down slowly.

Signs of normalization:

• Term structure flattening or flipping to contango
• Skew normalizing
• Realized vol declining
• Price action becoming range-bound

💡

Vol spikes fast and decays slow. The pattern is asymmetric.

Trading in Different Regimes

Your strategy should adapt to the regime:

Regime

Long Vol

Short Vol

Key Risk

Low Vol

Cheap but bleeding theta daily

Profitable but exposed to sudden spikes

Regime shift catches you

Normal Vol

Fair price

Fair price

No obvious edge

High Vol

Expensive - need big moves

Risky - catching falling knives

Continued elevation

Crisis

Very expensive

Dangerous

Anything can happen

Low Vol Strategy Considerations

• Long vol is cheap but time decay is relentless
• Short vol is tempting but regime shifts are brutal
• Consider longer-dated options if going long (more time for vol to materialize)
• Size conservatively if going short (the spike will come eventually)

High Vol Strategy Considerations

• Long vol is expensive: need very large moves to profit
• Short vol can work but timing is everything
• Spreads help reduce premium outlay
• Don't assume mean reversion is immediate - vol persists

The Vol Risk Premium

On average, implied vol exceeds realized vol. This is the volatility risk premium (VRP).

Why it exists: Option sellers demand compensation for bearing uncertainty. It's the "insurance premium" embedded in options.

But VRP varies by regime:

• Low vol: VRP often compressed or even negative
• High vol: VRP can be very large (IV >> RV)
• Post-crisis: VRP extremely high as IV lags the calming

This is why selling options has a statistical edge - you're collecting the insurance premium. But the edge is compensation for tail risk. When tails hit, they hit hard.

Common Mistakes

Mistake	Correction
Assuming current regime persists forever	Regimes change. Low vol doesn't last, neither does high vol.
Selling vol aggressively in low-vol regimes	This is picking up pennies. The spike will come.
Buying expensive vol in high-vol regimes	You need massive moves to overcome the premium.
Not tracking IV percentile	Context matters. 50% IV means different things at different times.
Ignoring realized vol	IV vs RV spread tells you if options are cheap or expensive.

Test your understanding before moving on.

Q: What is volatility clustering?

Q: How do low-to-high vol transitions typically happen vs high-to-low?

Q: What does it mean if IV is much higher than recent realized vol?

💡 Tip: Try answering each question yourself before revealing the answer.

See Also

• Vol Regimes Reference - More detail on regimes
• Vol Indices Reference - VIX, DVOL, and how to track them
• Lesson 7: Surface Dynamics → - How the whole surface moves

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