VIX Falls as Market Rallies

There has been a lot of talk lately about the Volatility Index commonly called the VIX. Investors often look at the VIX to determine how much fear there is in the markets. For a prolonged period, 2004-2006, the VIX traded at very low levels. For most of those years, it traded well below 20, suggesting not only that investors had little fear of risk, but also that they were complacent. However, the VIX started rising in 2007. It peaked in late 2008 above 80 as the financial crisis made front-page news.

Recent talk of the VIX has focused on its rapid decline. It is now below 30, yet still well above the 2004-2006 levels. This suggests investors have become less fearful of putting money at risk, but they are still far from being complacent.

The VIX is actually the instantaneous standard deviation from the Black-Scholes Option Pricing Model. Traders sometimes use this model to identify overvalued or undervalued options. The model relies on several variables, one of which is the underlying stock's instantaneous standard deviation. This variable is almost impossible to measure.

However, if all the other variables are known, the standard deviation can be backed out of the Black-Scholes equation. In the case of the VIX, the underlying stock is actually the S&P 500 Index.

The VIX tends to rise when the market sells off, but it falls when the market rallies. In other words, it is a better measure of downside volatility than overall volatility. Furthermore, the VIX is not a reliable forecaster. The market does not rally simply because the VIX falls.

In fact, it is more accurate to say that the VIX falls as the market rallies.

Comments

[Mad Hedge F...:]

And fall it will. Traders are making much of yesterday’s drop of the volatility index (VIX) under 30% for the first time since the Lehman bankruptcy in September. Please see my April 7 forecast that it would collapse from 40%. Are we now at the bottom of a 30%-50% range, or will 32% be the new ceiling on the way back down to the 10% we saw two years ago? Part of the confusion springs from a misunderstanding of what the VIX is by ordinary investors. It is just a mathematical guess about how big the next move in the market will be. A 40% VIX implies that one out of three days will see a 2.25% palpitation, and once a month we will suffer a 4.5% gyration. You can have the market drop 10%, rise 11.1%, remaining unchanged, but still generate a tremendously high VIX. The equation doesn’t care what the direction is. VIX unfairly picked up a bearish connotation because of the panicked rush by long side only investors to buy downside protection in falling markets, driving “put” implied volatilities through the roof. This is why investors associate a high VIX with falling markets. In the end, this debate can only be resolved in one way, and that is to the downside. Smart hedge funds that shorted out of the money calls on VIX higher up, are now taking profits. But the VIX will crash again when markets go to sleep, as they inevitably will. Believe me, trading around a low VIX is your worst nightmare. Traders don’t pull down million dollar compensation packages playing “Solitaire” on their computers.

May 21 07:54 AM