- Markets & Risk Newsletter
|
||||||
|
- The VIX: Fear and Volatility What if you could read the thoughts of millions of other traders at every moment? What if you knew their feelings and intentions? Since the founding of the NYSE in 1792 such a crystal ball has been the object of desire for every investor on the planet. In 1993 the Chicago Board of Options Exchange (CBOE) unveiled a tool that promised to come close to this stock market version of a fortune teller. The Volatility Index (VIX) is composed using a weighted blend of a wide distribution of option prices, which reflect how investors feel about the short-term future of the market. Specifically, in the words of the CBOE, the VIX "is calculated directly from the price quotations of nearby and second nearby S&P 500 Index options spanning a wide range of strike prices. The VIX calculation is independent of any theoretical pricing model." In more technical terms the daily value of the VIX is defined as the square root of the par variance swap rate on the S&P 500 index for a 30-day, forward-looking term. A variance swap is a financial instrument that facilitates the speculation on (or hedging of) the magnitude of price fluctuations (the variance) of a given underlying asset. Since volatility is the square root of variance, the VIX is calculated by taking the square root of the value of this theoretical swap on the S&P 500. A variance swap can be replicated using vanilla puts and calls and for this reason the VIX is calculated using a portfolio of option prices.
Investors use options to hedge against fluctuations in the price of securities, to speculate on share-price moves, or to bet that volatility, or stock swings, will increase or decrease. To objectively collect and package option price data would be like peering into the mind of every options trader. You'd get a clear picture of investor attitudes and confidence. Sure enough, for years the VIX index inversely followed the S&P 500. When stocks slid, investors increased options purchases and options prices rose-as did the VIX index. When stocks rose, investors had less interest in options, and the VIX declined. The range of the VIX, using the scale of the revised methodology introduced by the CBOE in 2003, generally went up and down between 10 and 25 index units.
During the recent financial crisis, the index shot up to a record value of 80. This event, in November 2008, confirmed the VIX's reputation as the "fear gauge." At the time, the S&P 500 had slumped to around 750. But the market continued to decline, hitting a bottom of 676 in March 2009. The VIX, however, stayed constant at levels between 40 and 50 despite the decline in March and the subsequent rally. As of May 1st the S&P 500 hovered at 872 while the VIX was at 36.
A VIX index at 40 for an extended period of time is unprecedented. During four prior periods in the past 20 years the VIX surpassed 40 but never stayed above that level for more than ten days. In contrast, between September 29 and April 5 it closed below 40 only nine times. Less Inverse Correlation - Why? During the past three months the VIX and the S&P have reduced their traditional highly inverse relationship. Perhaps this is because the VIX is fulfilling its true function as a measure of volatility. A traditional axiom of market analysts has been that the market falls much more quickly than it rises, or, as the saying goes, it melts down faster than it melts up. Hence "volatility" and "fear" have become synonymous. Volatility, though, means a high rate of change. From the end of the 2003 recession, the S&P's rate of change both up and down remained steady within a range of ten points on either side of zero. This relative calm ended in October 2008 when the rate of change began fluctuating within a much bigger arc-up to 20 points on either side of zero. That's volatility. Of course, what the VIX measures are the various and sundry predictions of the future held in the minds of millions of individual investors. None of these investors has a crystal ball. Most have the same market information. What the VIX hopes to glean is collective clairvoyance from sources who, as individuals, have none. For information on powerful risk-management tools that allow you to track and measure the risk of equity indexes, option prices, and multi-model volatility, contact PortfolioScience today. |
© 2000-2009 Portfolio Science, Inc. | ||
|
The RiskAPI® Add-In
Version 3.4.2 Now available.
|
|
|
What's New
Click for all new items: More |
|