This post was originally written on September 21, 2012 at www.optiontiger.com/understanding-vix-index/
The VIX Index, also known as the "Fear Index", is one of the most watched indices in the markets. The VIX Index is a measure of Volatility in the markets. You'd be forgiven if you believe that the VIX should go up when the markets are volatile, on the upside or the downside. But this is not the case. The VIX actually goes up when the markets go down, and goes down when the markets go up. (See Figure below - correlation between the VIX and the S&P 500 Index (SPX). Whenever there's an element of panic or crash in the markets, the VIX spikes up. In 2008/2009, it reached an all time high of 96 when the markets were at the lowest - SPX reading of 666. Since then its come close to 50 two times, once in 2010 and once in 2011, both when markets seemed to be crashing. So the SPX and the VIX are inversely correlated. But the VIX index is not a true "volatility" indicator, its a "fear" indicator.
Exactly how the VIX index is calculated will be the topic for another post. In this post, the goal is to try and use the VIX index as a forecasting tool for where the markets may be headed in the medium term (4 to 6 months). And we do this by analyzing the VIX Options in Figure II below, and understand where all the big players or the "smart money" players are positioned for the next 4 months. The graphic shows the Jan 2013 Option chain for the VIX index. On the left side you have the Call Options and the right side are the Put Options. Also shown is the Open Interest for both Options. Strike prices are shown in the middle.
There are a few observations we can make here -
1) The Open Interest on the Calls side is much higher than the Puts side, and it also spans a much larger range of strike prices on the Calls side. The VIX Index itself is at 14 today, and the smart money players have large Call positions starting from the strike price of 23 and goes all the way to 45 strike. This is the first indication that tells you that the smart money players are expecting the VIX index to rise to 20 or 25 or 30 or more in the next 4 to 5 months. If the VIX index rises, the SPX will fall.
2) The second and more interesting fact is the premium amounts for these Options. The index is at 14 today, so the At the money (ATM) Options are at 14. The ATM Puts at 14 strike price are going for 25 cents, but look at the ATM Calls. They are going for $7.15. In general in all stocks and index options, the ATM Calls and Puts are somewhat equal. This makes sense because the likelihood of the stock going up or down at any given time is 50-50. But the ATM VIX Calls are priced 30 times that of the Puts. This is again another indicator that there is serious demand for the Calls and not much for the Puts. This again means smart money is expecting the markets to go down in the 4 months by quite a bit.
3) Third interesting point - on the Puts side, look at the strike price of 12 or lower. These Options are virtually going for nothing, 2 cents or 5 cents. This means smart money thinks there is no chance of the VIX index going below 12, so we are very near to a market top right now.
4) The 14 Put is going for 25 cents. To find the corresponding Option on the Calls side for 25 cents, we have to go all the way to the 50 strike price.
The Smart Money is clearly positioned for the VIX to increase in the next 4 months. This means markets will be coming down. Nobody knows what will happen, but at least we can see how the big players are positioned here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.