The VIX is up 14% as I type.
At its core, the VIX is a mean-reverting gauge. When it closes more than 10% away from its 10-day simple moving average (SMA), we consider that move a bit extended. Right now, the VIX sits about 11% above its SMA. In addition, the Relative Strength Index (RSI) is quite high at 97.51.
This is a pretty powerful blast off a rather dull stretch. So, if you’re a contrarian, it’s time to back up the truck and buy stocks, right?
Not so fast.
Just like you don’t need a weatherman to know which way the wind blows (or something like that — I’m not a Dylan fan), you don’t need the VIX to tell you the market sold off. In fact, the VIX is this strong precisely because the market opened particularly ugly today.
The VIX indexes the volatility of S&P 500 (SPX) options. The calculation formula incorporates all qualified SPX strikes, i.e., those that have more than eight days until they expire (so August still figures in for another day), are no more than two expiration cycles away (so September is in there, too), and that have a non-zero bid.
The closer the strike to the SPX “money,” the greater weight it has in the VIX calculation. But remember, SPX options trade at a steep skew. What that means is that the lower the strike price, the higher the implied volatility on the option.
Thus, when SPX trades lower, the “money” is now a lower strike than it was yesterday. And that lower strike already trades at a higher volatility than the at-the-money (ATM) strike from yesterday did.
How much higher?
What if we simplify the VIX for one moment and say it indexes one option, the ATM SPX strike in September at this moment in time. Yesterday’s ATM strike was 1,120. The September 1,120 line in SPX trades at a 19.8 implied volatility. Right now the ATM strike is 1,095, and it trades at a 21.9 volatility. So this simple VIX would rally 2.1, or about 11%, simply by virtue of SPX moving toward a strike that already trades at a higher volatility.
Viewed through this lens, a 13% rally in the VIX becomes less predictive and more a case of self-fulfilling prophecy.
This is why I believe the best use of VIX is to find times when it tells you something you don’t already know. Today is not one of those times.
Follow Adam Warner on Twitter @agwarner.
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