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What is the VIX and what is it good for?

by Hollis Templeton
Dec 03, 2008


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While trading in highly volatile markets leaves most investors holding onto their seats, daring speculators have the opportunity to capitalize on Wall Street’s fear and rake in big bucks.

How do they do it? One way is to trade the Chicago Board Options Exchange Volatility Index, the VIX. As investors expect wild movements in the stock market, options typically become more expensive—and the VIX measures by how much.

After surging upward in October, the VIX climbed to an all-time closing high of 80.86 on Nov. 20 when the Standard and Poor’s 500 Stock Index dropped to 752.44, its lowest close since 1997. These record breakers illustrate the unprecedented level of fear that crept into the markets after being crippled by the U.S. housing crisis and uncertainties about the financial bailout this fall.

At the same time, recent market swings pushed trading volume for CBOE’s VIX options to 1,431,609 contracts in November, a 12 percent increase compared with the same month a year ago.

As financial news buzzes with talk of market volatility, the amateur investor is forced to ask: What exactly is the VIX?

Established in 1993, the CBOE’s VIX is the benchmark index for how much market prices are going up and down every day. Its value is determined, like that of all derivatives, by buyers and sellers in the marketplace, so the VIX can be a good gauge of investor sentiment.

In 2004, VIX futures were launched on the CBOE Futures Exchange and in 2006 options on the VIX were launched on the Chicago Board Options Exchange. The index upon which these futures and options are based measures the market’s expectation of near-term (30-day) volatility of the S&P 500 stock index option prices. The VIX is casually referred to as Wall Street’s “fear gauge.”

“Never has that moniker been more apt than over the past few months,” said Peter Lusk, an instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange. “The world’s markets have become much more volatile, reflecting the economic fault lines that have recently surfaced.”

Under normal conditions, the VIX is around 19 or 20, according to Lusk. "When the VIX is at 30, that depicts anxiety in the market with some stocks at new lows," he said. "Some traders used the VIX as a gauge to scoop some of those 'discounted' stocks. With the VIX now at 62, those bargain stocks were not really a bargain after all."

Clearly, volatility isn’t always a bad thing. "If you had purchased an option you are now long on volatility," Lusk said. "Remember, when volatility increases, both call and put prices increase in value. Now you are trading volatility."

The VIX means different things to traders versus investors. While investors may buy and sell VIX futures and options to diversify their portfolios because of its inverse relationship with S&P stock options, traders use it as a market indicator, and as a trading vehicle itself.

“Increased volatility is particularly helpful for traders in that they are able to capture larger market swings with their positions,” explained Bill Luby, a San Francisco-based trader and full-time investor, who carefully tracks the VIX and authors the blog Vix and More.

While futures trading obliges contract holders to make or take delivery of a product on a specified date, options contracts allow more leeway. VIX options grant the buyer the right, but not the obligation, to take a position—in this case, on market volatility—previously held by the seller of that option.

The CBOE, the self-described “home of volatility products,” reported record trading volumes on VIX products in recent months. A record-breaking 3.27 million CBOE Volatility Index options contracts were traded in September with volume waning only slightly to 3.15 million contracts in October. On Sept. 16, nearly 427,000 CBOE Volatility Index options contracts were traded, breaking a daily volume record.

“For investors, increased volatility is usually more problematic because more often than not it is associated with falling markets,” Luby said.

Before October 2008, the VIX had surpassed 40 only four times. Previous records were set during the Asian financial crisis in 1997, the collapse of hedge fund Long Term Capital Management in 1998, the aftermath of the 9/11 terrorist attacks and when WorldCom Inc. filed for bankruptcy in 2002.

On the bright side for investors is the fact that the volatility index usually moves in the opposite direction of the S&P 500 and the Dow Jones Industrial Average. According to the CBOE, the VIX has historically moved against the S&P 88 percent of the time. The VIX will climb an average of 16.8 percent on days when the SPX falls 3 percent or more.

Going back to October’s record-high VIX, the volatility index price fell 13.10 to 66.96 on Oct. 28 from 80.06 on Oct. 27, a one-day decline of 16.4 percent. The S&P 500 price rose that day 10.8 percent from 848.92 on Oct. 27 to 940.51 on Oct. 28.

On Oct. 10 the S&P 500 reached a record-breaking intraday low of 839.80. That same day, the VIX topped 70 for the first time ever, with a closing high of 69.95 and an intraday high of 76.94. The Dow plummeted to a 52-week intraday low of 7773.71 that day and has not closed above 10,000 since.

The VIX is “something with a lot of eyeballs on it,” said Elmhurst, Ill.-based commodity trading advisor and futures broker John Lothian. “You certainly have to respect that it as a key indicator because we are in an extremely volatile time.”

On the other hand, Torben Andersen, professor of finance at Northwestern University’s Kellogg School of Management, suggests that the VIX might not be the most accurate predictor of actual market volatility.

According to a study he conducted on the construction, interpretation and success of the VIX in predicting option-based volatility, Andersen and co-author Oleg Bondarenko found that the VIX almost always exceeds realized volatility.

The team’s research, based on 15 years of data on options prices, VIX prices, and U.S. Treasury bill rates, showed that since the VIX is based on only a select range of stock prices, it is only a variant of an index called CIV or “corridor implied volatility.”

CIV, which Andersen says had not been explored empirically before this research, can be narrowed to look at market volatility more accurately. In the future, narrower CIV-style measures of volatility may lead to more accurate option-based volatility forecasts, said the researchers.

What does 2009 have in store for market volatility?

Luby predicts that the fear bubble is close to bursting. “Generally a high VIX does not persist for very long, as value-oriented investors will tend to start buying more aggressively when the VIX is high and as markets show signs of bottoming,” he said.

A VIX option currently costs around $65. “But the index can go down if people become less nervous about the state of the market, or could rise if they become more concerned about the U.S. economic health,” said the CBOE’s Lusk.

“I believe fear is on the way down over the course of the next few months,” Luby said. “It is likely that we will have some additional instances of increasing fear, but if none of these results in new VIX highs…there is a very high likelihood that the VIX—and fear—will be on the way down.”

The VIX closed at 62.98 Tuesday, down 5.53 or 8 percent.