Anyone who follows the market is very familiar with the term ‘volatility’. Generally when people talk of highly volatile markets they are referring to the over all market going down which sees volatility rise and low volatility in a stable up trending market.
Seems obvious. Why do we care about volatility or care what the VIX is?
This price/volatility relationship in the market indexes (S&P 500, Dow, NASDAQ) has held true since the birth of the indexes due to the driving forces in human nature of fear and greed. Having this consistently stable relationship in the index gives a tremendous edge to managed options strategies by being able to use price to mitigate the risks of volatility while continuously profiting from time.
In recent years the VIX, or volatility index, has become more and more of a central part of a market enthusiast watch lists. So what exactly does the VIX measure? At its core, the VIX measures the volatility of the S&P 500. A more advanced definition is that the VIX tracks the implied volatility of a basket of options on the S&P 500.
From Investopedia here is a dive into the technicals. While the formula is mathematically complex, theoretically it works as follows. It estimates the expected volatility of the S&P 500 index by aggregating the weighted prices of multiple SPX puts and calls over a wide range of strike prices. All such qualifying options should have valid non-zero bid and ask prices that represent the market perception of which options' strike prices will be hit by the underlying during the remaining time to expiry. For detailed calculations with example, one can refer to the section “VIX Index Calculation: Step-by-Step” of the VIX whitepaper.
For many, you may own stock in various industries and sectors that are not necessarily in the S&P 500 but by following the VIX you can get a good idea of how volatile the market is on average. The mean or average level of the VIX is around 20. From our experience, the market will be fairly calm with the VIX below 16 and really start to whip around when it gets around 25 to 30.
One frequently asked question is “You can trade the VIX? I thought that it was not a tradable product?” This is both right and wrong. You cannot trade the VIX index itself, but you can trade VIX futures and options contracts on those futures.
Just as there are many ways to interpret a great painting, there are many ways to interpret the VIX and back out useful information. It can be viewed as how much volatility there is in the market, how much it costs to hedge a portfolio, or in a very simplified manor as the ‘fear index’.
At Blackpier we view the VIX as another way to gauge what other investors are thinking. I’ll illustrate with an example. Say the S&P 500 is trading at 2,000 and the VIX is at 16. The next day the market gaps down to 1,980 and the VIX climbs up to 20, a 25% move. The following day the S&P goes right back to 2,000 and one would expect the VIX to move back to 16 but it doesn’t. Instead it only falls back down to 18.
In this case, we would see that there is still uncertainty in the market and that traders believe that there is now more risk in the market than there was previously even though the S&P is at the same level.
Another example of information gained is when the VIX gets to its extremes. Over the past few years we have seen times when the VIX gets to a very historic low level (11 or lower) and instead of the VIX going down when the S&P 500 advances we see it go up. This is called inversion, where volatility goes up when the market goes up. It doesn't happen too often but generally will at extreme lows in volatility. Again this gives us information about what market participants are doing in the S&P 500 options market: Hedging for a move lower.
There can be many in depth discussions on the VIX, VIX options pricing, other products based on the VIX, and the correct way to view the VIX. We hope this short article has given you a good introduction to what the VIX is and some of the ways in which to interpret the index. If you have any questions or would like to discuss the topic further, please to not hesitate to reach out to us.