I have elaborated (maybe too much) on what the VIX can’t do, but how about what it can do?
To begin to understand the CBOE Volatility Index (VIX), you must know the concept of implied volatility. The price of an option derives from an equation involving several fixed variables (strike price, price of the underlying instrument, time until expiration, dividends and interest rates) and one variable one (implied volatility). Implied volatility is a proxy for expectations of future standard deviation. Since we know the price of an option at any given time, we can “solve” for implied volatility.
The level of implied volatility gives a window into market sentiment. The higher it goes, the greater the fear level. Every option on every options screen carries its own implied volatility. Multiply that by every listed option in America and you have a truckload of data to sift through to come to any broader conclusions about sentiment.
The VIX takes a very, very narrow slice of that vast marketplace. It measures the implied volatility of a hypothetical S&P 500 (SPX) option with 30 days until expiration. It’s a fairly representative snapshot of what’s going on in the options marketplace.
The VIX was around in the 1990s, but rarely discussed. Perhaps that’s because VIX generally moves in opposition to the market (about -.66 correlation), and when everything was going up, no one cared much about a broad-based “fear” gauge. But the last decade has seen quite the choppy market, and “bug” of moving inverse to stocks became a “feature.”
It has become popular to chart the VIX as if it was a stock. But it’s not a stock, it’s a statistic. It has a non-zero low and pretty much anything as a potential high. It does not have supply and demand like a stock either.
What it does do, though, is mean revert the majority of the time. In other words, when it gets stretched one way, it tends to snap back toward the “mean.” The trick is defining the “mean” though.
One definition would involve comparisons to short-term moving averages. One popular rule states that when the VIX moves 10% above (or below) it’s 10-day simple moving average (SMA), it’s overbought (or oversold) and likely to revert back to the SMA. So when VIX moves 10% above the SMA, you may start looking for it to decline. Since the VIX moves inverse to the market, that implies that you can start looking for a lift in the overall market.
Of course, this is the classic type of rule that works until it doesn’t. And when it doesn’t, watch out!
As of Friday’s close, the VIX was 90% above its 10 day SMA. That’s not a misprint.
That’s a bit of an outlier level, to say the least. It’s pretty clear the VIX, and volatility, have become overbought. So, in theory, that was bearish for the VIX and bullish for the market.
Of course, the VIX flashed a bullish signal when it got 20% above its SMA early last week, and look what happened, the market got creamed.
Another way to look at the VIX is to relate it to the realized or historical volatility (HV) of SPX itself. Realized volatility refers to the volatility of the underlying instrument over some defined time frame. While the VIX looks forward and anticipates SPX volatility over the next 30 calendar days, realized volatility looks backward and measures in trading days. So, while comparisons prove useful, they also have a bit of an apples-to-oranges relationship.
I personally prefer looking at short-term realized volatility. That’s because options price off the feel of the market right now.
Long story short, 10-day realized volatility (or HV) of the SPX has soared from 7.5 a few weeks ago to about 25 now. And 20-day HV is about 22, so you can clearly see that number lags the market a bit. The VIX typically carries about a 4-point premium to HV. It closed Friday with about a 16-point premium to the 10 day HV.
Finally, it’s useful to compare VIX itself to the various VIX futures and VIX options. The VIX can exhibit all sorts of noise, so VIX futures are useful for calibrating the “mean” assumptions we noted above. For the lion’s share of the past 11 months, VIX futures carried large premiums to the VIX itself, as well as an upsloping term structure (i.e., the longer dated the future, the greater the premium over the VIX). This told us there was a bit more fear in the system than met the eye as the “market” expected the VIX to lift. That expectation proved wrong most of the time, until recently when it proved massively correct.
Last week, we had the exact opposite. May VIX futures traded at as much as a 9-point. discount to the “cash” VIX on Friday, closing above $8. It narrowed today to about $1.50.
So, to answer the questions I posed earlier of how you do use the VIX, I would compare it to realized volatility of the underlying SPX, and would compare it to its own moving averages and, to a lesser extent, would compare it to VIX futures.
It’s clearly went off-the-charts high by all metrics last Friday. However, hindsight is 20/20, and it was high before Friday, too.
The next question to ask then is one of interpretation. It’s clear there is massive fear lurking out there. Do you find that fear is a leading indicator, and bearish, or a contrary tell and bullish.
And that’s a question everyone has to ponder themselves. The VIX led us down last week. Will that pattern continue now that it’s considerably higher, even after today’s record drop?
