VIX - CBOE Volatility Index
I alluded to the volatility index (symbol: VIX) about two weeks ago in my market commentary and today I’d like to expound a little more on what it is and how it can be used.
The Chicago Board of Exchange Volatility Index is a measure of the implied volatility of S&P 500 options. These index options are typically 30-day options and, as a result, one can look at the VIX as a indicator of the broad market’s expectation for volatility in the S&P 500 which, inappropriately or not, typically represents to us the general health of the market. The VIX graph became increasingly popular last month as it is typically known as a “fear index” given that markets usually become volatile due to uncertainty and in the case of the markets uncertainty is always a cause for fear. As such, the VIX graph was especially poignant during a time when few knew just how bad the subprime contagion was and the resulting effect this had on the equity markets. During July and August, we saw the VIX drive to three-year highs yet this topping out so to speak seemed also to signal good news to the market. Why?
Well, the VIX is quoted in percentage points and, as mentioned before, basically describes how far up or down the market expects the S&P to move in the next month. Thus a high VIX, says that the market expects a large swing in one direction or the other, hence it is a measure of the market’s uncertainty. If you are interested in how exactly this is calculated, take a gander on Google for options pricing models (like Black Scholes). Basically, it involves taking the prices for S&P 30-day options and running them backwards through a pricing model to determine the volatility implied by them. Nearly all options pricing models are built around some sort of assumption of volatility. Typically, the more highly volatile one expects a stock to be, they one is willing to pay for their options.
Well, take a look at the following graph where I match up the VIX graph with the S&P 500 chart.
As you can tell, tops in the VIX chart seemingly correspond to bottoms in the S&P. This is representative of the fact that volatility will reach its absolute highest as sellers finish selling off and buyers flock in to pick up the pieces. Is VIX the be all and end all for market sentiment? Not at all. Many believe that it isn’t even that strongly correlated with the market. It is afterall derived only on 30-day index options as opposed to general equity options which typically trade from 2 to 6 months. Further, sometimes its difficult to pinpoint the exact source of market volatility. But, when large macroeconomic influences are hitting the markets, the VIX can be your best friend as an early indicator of where markets are headed and when things look to be turning around.
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