WHAT IS THE VOLATILITY INDEX (VIX) AND HOW DO YOU USE IT?

The VIX (Volatility Index) is a much touted index in financial circles, but what is it and what does it represent? You may hear it called the “fear index,” but even that is a misnomer and not an accurate representation of what it is. Certainly there are times when the price of this index is interpreted as fear, but other times it can reflect complacency.

VIX Index Monatschart
VIX Index Monthly Chart

WHAT IS THE VIX INDEX – DEFINITION

The VIX is a number derived from the option premium prices in the S&P 500 index (an index that includes 500 large-cap stocks).

It is a good indicator of the expectation of market volatility, note I said “expectation”, it is not representative of actual volatility or what will happen. This is a very important point; it is just a general assumption based on the premiums investors are willing to pay for the right to buy or sell stocks.

This premium in options can loosely be defined as risk. Just as with other forms of insurance, the greater the risk, the higher the premiums, and the lower the risk, the lower the premiums. When the option premium falls, the VIX falls, and when premiums rise, the VIX rises.

VIX Options Calculation

The VIX is not set by a single person, but rather is the result of millions of transactions by millions of traders from around the world. Buyers and sellers move option prices, more buyers and premiums go up, more sellers and premiums go down. The VIX takes a weighted average of all these option prices in the S&P 500 index and derives a single number called the VIX. This one VIX number gives us a general idea of whether investors are paying more or less for the right to buy or sell the S&P 500 index.

You can read more specific details at http://www.cboe.com/vix.

What does this number mean?

For those interested in what the number represents mathematically, here it is in the simplest terms. The VIX represents the S&P 500 Index +/- percentage move, annualized for one standard deviation. Example, if the VIX is currently at 15. This means that based on the option premiums in the S&P 500 index, the S&P is expected to remain in a +/- 15% range (representing one standard deviation) 68% of the time over the course of a year.

When is the VIX high or low?

Historically, the VIX below 20 means that the market is forecasting a rather healthy and low-risk environment. However, when the VIX drops too low, it is an expression of complacency, and that is dangerous and means that everyone is optimistic. Remember the story of the “Shoe Shine Boy”: when everyone is bullish, there are no buyers left and the market collapses.

When the VIX rises above 20, fear begins to enter the market and a higher risk environment is forecast. If it rises too high, then everyone sings the “chicken song.”

Remember, the VIX is not set by any one person or even groups of people; it is determined solely by the flow of orders from all buyers and sellers of options. One could extrapolate an equilibrium level where the market (risk premium) is fairly priced based on the economic landscape.

If we look at the historical points of the VIX, we see that during the height of the great housing crisis in 2008 and 2009, the VIX shot up to levels well above 50. Think about that for a second and what that means. For our understanding of the model, the options are pricing that the S&P 500 index (the largest 500 companies) will be in a range of +/- 50% over the course of the year, 68% of the time. At one point, the VIX rose to 85, which are insane levels that can never be sustained for very long. The VIX quickly dropped back down and then went too far in the other direction and dropped below 15. Again during the crisis the VIX wanted us to believe that everything was fine and that the S&P 500 index had a very low probability of radical moves, again the VIX was wrong and went back up.

So where is the mean?

That’s a very good question. I think it depends on two different but distinct factors. First, it’s the perception of the political and economic climate, and second, it’s the actual fundamental soundness or the math that brings us back to reality. There is the perception and the mathematical reality, and the VIX is somewhere in between. In my personal opinion and from experience, based on the current geopolitical environment, I would say that the VIX has a fair price in the 20 point range (+/- 2). However, this midpoint will change as economic, market and political conditions change.

WHAT IS THE VIX AND HOW IS IT CALCULATED?

The VIX was created in 1993 and later updated in 2003 to measure the expected volatility of the stock market over the next 30 days in real time. It is a measure of expected future volatility based on call and put options placed by traders on S&P 500 stocks (click here for our options trading guide). The S&P 500 (SPX) index is considered a leading indicator of the U.S. stock market as a whole, and investors use it to measure the level of risk in the market.

The VIX estimates how volatile the market will be by aggregating the weighted prices of S&P 500 puts and calls over a wide range of strike prices. More specifically, the VIX is calculated by looking at the midpoints of the real-time bid and ask prices of S&P 500 options.

Standard SPX options expire on the third Friday of each month and weekly S&P 500 options expire on every other Friday. Only SPX options that expire on Friday are used to calculate the VIX, and they are weighted to provide a measure of the expected volatility of the S&P 500 index with a constant maturity of 30 days according to the CBOE.

Intraday VIX values are based on SPX option bid and ask prices every 15 seconds, and are intended to provide expected volatility at a specific point in time, so they are often referred to as “indicative” or “spot” values. VIX spot values are calculated between 3:15 a.m. ET and 9:15 a.m. ET, and again between 9:30 a.m. ET and 4:25 p.m. ET.

For you math whizzes out there: Here is the generalized formula for calculating the VIX:

VIX Formel
VIX Formula

Is the VIX correct?

I believe the volatility of the VIX is a direct representation of man’s inability to effectively understand risk and put a price on the unknown. The VIX had remained in the low 20’s in 2008 when we all knew that problems were rapidly spiraling out of control, the VIX rose, correcting its earlier assumption. However, it went way beyond reality as panic drove option premiums (insurance prices) into the stratosphere. When it fell, it quickly overcompensated. The VIX suffered huge whiplashes in 2009, 2010 and 2011 as it tried to overcompensate and find some balance between perception and math.

The VIX has the same human perception error as the stock markets, which often drive stock prices too high or too low. Human perception can quickly lead to greed or fear instead of focusing on the math and fundamentals. It is easy to get sucked into the abyss of raging social idiocy. Logic, reason and wisdom are cast aside when we are driven by irrational greed or fear.

“Hidden Volatility.”

I have a saying known as “hidden volatility”; that is when the market premium [option premium] contracts as the stock markets begin to consolidate. We know that the market will not consolidate [form a wedge] indefinitely, and when it breaks out (up or down), it could be a violent move. I equate the term “hidden volatility” to a compressed spring. We can’t see the energy in that spring, but we know it’s there, and when the energy is finally released, it moves quickly and violently. How much energy is needed and how long that energy can last to keep the spring contracted is something physics can answer; however, in the marketplace, this equation is determined by supply and demand. In many cases, it is a catalytic event that releases the force when one side steps back and forces the other side to surrender completely.

Hidden volatility occurs when volatility occurs in both equity and option premium contracts. Sometimes this is referred to in the media as “greed” or “complacency,” but the reality is that the option premium is below the mean “should” and continues to decline. This is subjective, but can certainly be seen and experienced in its extremes.

To me, this is usually a big warning sign that the market is about to experience a pretty big and violent correction, usually to the downside.

Trading the VIX

The VIX is both a tradable cash-based options index and a futures index.

Some VIX options and futures products are: UVXY, VXX, VIIX.

The VIX options and futures can be used to hedge a long portfolio as well as to take a position in the VIX.

When trading VIX products, it is important to understand their inverse relationship to the equity markets. The VIX will generally rise in value (price) when the stock market (especially the S&P index) declines.

To hedge a long portfolio, one could buy call options or take a long VIX futures position. The general idea is that if the long portfolio falls sharply in price, the VIX will rise in price and the call options would rise in value. This is a typical hedging method for large long basket positions.

Sometimes it is easier to think of trading VIX options than it is to think of trading options in the S&P. If you believe the S&P is going down sharply, then buying VIX call options would benefit. If you believe the S&P is going up sharply, then buying VIX put options would benefit.

The most common problem new traders have in the VIX markets is understanding the inverse relationship.

Conclusion

The VIX is a helpful tool and indicator. It gives a current and accurate measure of where the option premium is trading in the S&P 500 index. However, it is very important that we understand that the VIX is neither right nor wrong in its current or projected measurement of the volatility of the S&P 500. It is only where the market is willing to trade the premium or current risk measurement. At the extremes, we see that it is wrong and quickly tries to compensate as buyers quickly become sellers or sellers quickly become buyers. It is driven more by perception and the human condition of fear and greed than by any other force.

Our job as investors, traders and risk managers is to understand what it is and what it is not – to find and assess a range of accuracy and then determine if human fear or greed is driving it to one extreme or the other.

There are huge opportunities at those ends of the extreme, because you have to see the fear or greed of others as an opportunity and not get sucked in like the rest of the lemmings.

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