How Is VIX Used?
How is VIX Used?
The Cboe Volatility Index (VIX) is a consistent measure of the market’s expectations for the volatility of future prices changes for the S&P 500. The number quoted as VIX is a market consensus of how volatile the price behavior in the S&P 500 is expected to be over the next 30 calendar days. That’s the basic definition of VIX and was the goal in creating VIX, but how have practitioners incorporated VIX into the view of the markets?
Fear Index
VIX is often referred to as “The Fear Index”. There is a little truth to this moniker as VIX does rise rapidly when the S&P 500 comes under pressure. For example, the chart below shows the S&P 500 and VIX over the first ten weeks of 2018. Notice when the S&P 500 quickly moved lower in early February that VIX spiked to higher levels. This sort of price action is what has resulted in VIX be called a fear index.
Data Sources: Bloomberg and Cboe Global Markets
Referring to VIX as a fear index is an oversimplification of VIX. It rises as the S&P 500 moves lower, but this is a reflection of stocks being more volatile during periods of market stress and not necessarily a reflection of concern about the direction of stock prices. Moves in VIX are considered relative to the current market environment as well as relative to the price changes in the S&P 500.
Defining the Market Environment
VIX was created in 1993, but the data for VIX stretches back to the first day of 1990. Over this time period the closing price for VIX has ranged from just above 9 to slightly over 80. The yearly averages have also had a wide range, from a low of 11.09 in 2017 to 32.69 in 2008.
The average VIX over a period of time often defines the market environment. Practitioners will use the term “volatility regime” with the definition of a low or high volatility regime being indicated by the level of VIX. The chart below shows the high, low, and average closing levels for VIX by year from 1990 to 2017.
Two periods that are generally considered high volatility regimes are highlighted on the chart. The other periods may be considered transitional or low volatility regimes. At times when the market is in a high volatility regime VIX at 20 may actually be considered low, while in a low volatility regime VIX at 20 may be considered high. This is similar to a 60 degree day in Chicago in February being warm, but a 60 degree day in July being considered cold. Whether VIX is considered high or low should be taken in the context of the current volatility regime.
Option Expense
Although an oversimplification, implied volatility may be considered an indication of whether option prices are considered cheap or expensive. When an option price moves higher or lower and no other pricing factors change, the price change is a result of volatility expectations moving higher or lower.
Many traders will use VIX as an indication of the relative price of options. All else being the same, if VIX was 10 a month ago and is now at 20, SPX option premiums will be higher than they were a month ago. This is only part of the puzzle to know if an option was truly expensive or cheap, but a common use of VIX is to define expensive or cheap.
When we purchase a stock we do not know if the stock was a good purchase until the future. That is, we don’t know if we got a good entry point until we see if the stock moved higher or not. This is similar with option prices and implied volatility. If the volatility implied by an option price is lower than the market volatility that follows (realized volatility) then the option was underpriced.
Technical Indicator
VIX is a forward looking measure based on market pricing. Because it is a consensus of the market’s expectations and is consistent in the method of calculation, traders have embraced VIX as a technical indicator. VIX gives everyone the ability to easily compare volatility expectations today versus any period back to 1990.
When VIX is rising, this may be interpreted as increased buying pressure for SPX options. The buying pressure pushes market prices higher, just like with a stock. The implied volatility that is calculated from these options rises in sync with the higher option price.
One of the most common uses of SPX options is to purchase puts for portfolio protection. In fact, with very few exceptions, more SPX puts than call trade daily. Increased demand for SPX puts, which would result in higher VIX, may signal increased concern among market participants regarding a potential drop in stock prices. There are several other factors that relate to VIX with respect to market analysis, such as VIX futures pricing relative to VIX and SPX skew, but these methods have their roots in VIX.
Conclusion
The creation of the Cboe Volatility Index introduced a tool that is used in several different ways. The few uses mentioned in this article just scratch the surface at how VIX is used when analyzing the market. VIX traders and observers are innovative and continue to develop new approaches of using VIX in their toolbox to approach their own risk management needs.