Tuesday, April 29, 2008

Ten Things Everyone Should Know About the VIX

I have had quite a few requests to present some introductory material on the VIX, so with that in mind I offer up the following in question and answer format:

Q: What is the VIX?
A: In brief, the VIX is the ticker symbol for the volatility index that the Chicago Board Options Exchange (CBOE) created to calculate the implied volatility of options on the S&P 500 index (SPX) for the next 30 calendar days. The formal name of the VIX is the CBOE Volatility Index.

Q: How is the VIX calculated?
A: The CBOE utilizes a wide variety of strike prices for SPX puts and calls to calculate the VIX. In order to arrive at a 30 day implied volatility value, the calculation blends options expiring on two different dates, with the result being an interpolated implied volatility number. For the record, the CBOE does not use the Black-Scholes option pricing model. Details of the VIX calculations are available from the CBOE in their VIX white paper.

Q: Why should I care about the VIX?
A: There are several reasons to pay attention to the VIX. Most investors who monitor the VIX do so because it provides important information about investor sentiment that can be helpful in evaluating potential market turning points. A smaller group of investors use VIX options and VIX futures to hedge their portfolios; other investors use those same options and futures as well as VIX exchange traded notes (primarily VXX) to speculate on the future direction of the market.

Q: What is the history of the VIX?
A: The VIX was originally launched in 1993, with a slightly different calculation than the one that is currently employed. The ‘original VIX’ (which is still tracked under the ticker VXO) differs from the current VIX in two main respects: it is based on the S&P 100 (OEX) instead of the S&P 500; and it targets at the money options instead of the broad range of strikes utilized by the VIX. The current VIX was reformulated on September 22, 2003, at which time the original VIX was assigned the VXO ticker. VIX futures began trading on March 26, 2004; VIX options followed on February 24, 2006; and two VIX exchange traded notes (VXX and VXZ) were added to the mix on January 30, 2009.

Q: Why is the VIX sometimes called the “fear index”?
A: The CBOE has actively encouraged the use of the VIX as a tool for measuring investor fear in their marketing of the VIX and VIX-related products. As the CBOE puts it, “since volatility often signifies financial turmoil, [the] VIX is often referred to as the ‘investor fear gauge’”. The media has been quick to latch onto the headline value of the VIX as a fear indicator and has helped to reinforce the relationship between the VIX and investor fear.

Q: How does the VIX differ from other measures of volatility?
A: The VIX is the most widely known of a number of volatility indices. The CBOE alone recognizes nine volatility indices, the most popular of which are the VIX, the VXO, the VXN (for the NASDAQ-100 index), and the RVX (for the Russell 2000 small cap index). In addition to volatility indices for US equities, there are volatility indices for foreign equities (VDAX, VSTOXX, VSMI, VX1, MVX, VAEX, VBEL, VCAC, etc.) as well as lesser known volatility indices for other asset classes such as oil, gold and currencies.

Q: What are normal, high and low readings for the VIX?
A: This question is more complicated than it sounds, because some people focus on absolute VIX numbers and some people focus on relative VIX numbers. On an absolute basis, looking at a VIX as reformulated in 2003, but using data reverse engineered going back to 1990, the mean is a little bit over 20, the high is just below 90 and the low is just below 10. Just for fun, using the VXO (original VIX formulation), it is possible to calculate that the VXO peaked at about 172 on Black Monday, October 19, 1987.

Q: Can I trade the VIX?
A: At this time it is not possible to trade the cash or spot VIX directly. The only way to take a position on the VIX is through the use of VIX options and futures or on two VIX ETNs that are based on VIX futures: VXX, which targets VIX futures with 1 month to maturity; and VXZ, which targets 5 months to maturity. An inverse VIX futures ETN, XXV, was launched on 7/19/10. This product targets VIX futures with 1 month to maturity. As of May 2010, options have been available on the VXX and VXZ ETNs.

Q: How can the VIX be used as a hedge?
A: The VIX is appropriate as a hedging tool because it has a strong negative correlation to the SPX – and is generally about four times more volatile. For this reason, portfolio managers often find that buying of out of the money calls on the VIX to be a relatively inexpensive way to hedge long portfolio positions. Similar hedges can be constructed using VIX futures or the VIX ETNs.

Q: How do investors use the VIX to time the market?
A: This is a subject for a much larger space, but in general, the VIX tends to trend in the very short-term, mean-revert over the short to intermediate term, and move in cycles over a long-term time frame. The devil, of course, is in the details.

[Last updated on 7/22/2010]

18 comments:

Eric J. Fox said...

VIX is at a four month low here at 20. Might be a good time to buy VIX calls?

Bill Luby said...

Hi Eric,

You can make a case to wait until after the Fed announcement, but I think long volatility looks like a good play right now.

Cheers and good trading,

-Bill

Anonymous said...

bill

is there any volatility measure for the FTSE 100 Index in the UK?

Cheers
James

Bill Luby said...

James,

I am not aware of any volatility index for the FTSE 100, though I must confess that I have limited familiarity with the European markets.

For what it is worth, I have seen several studies that have looked at historical volatility for the FTSE 100.

Readers, feel free to chime in with the definitive word on this.

Cheers,

-Bill

Eric J. Fox said...

Good thing I didn't buy VIX calls...now at 18.49 but of course they trade kind of funny.

Bill Luby said...

Getting the timing right on the next VIX spike can be frustrating. Frankly, I'm surprised that the VWSI (VIX Weekly Sentiment Indicator) only closed at +1 yesterday and is at just +2 today -- suggesting a fairly neutral outlook on volatility over the next 1-2 weeks.

This may be an case where it pays to wait until there is evidence of some topping action, then buying some options with the expectation that the counter trend will be sharper than most suspect.

FWIW, I have no position in the VIX at the moment.

Cheers,

-Bill

Ryan Ward said...

Hi Bill,

I'm of the opinion that the VIX is signaling extreme complacency, but not exactly sure about the best way to put this view into action.

Does buying September or November calls make sense if we think that poor Q2 earnings will get the bears rolling again?

I guess I'm saying that I really like going long volatility but unsure of the timeframe or most reasonable way..

Thanks,
Ryan

Eric J. Fox said...

Ryan...the problem with betting on a poor Q2 earnings report to boost the VIX is that a poor Q1 earnings report did not boost it. The market seems to be taking poor earnings in stride for the time being. I think the VIX low the last few years is somewhere around 12 so there is still considerable downside.

Anonymous said...

Hi Bill,

do you know where can i find those volatility indices for currencies that you mention? tried everywhere but cannot find them.
hey, really thank you for this interesting blog.

ciao
Eugenio

Bill Luby said...

Ryan,

Timing the next spike always seems to be the hardest part. If things get ugly, I don't think you will have to wait for another earnings cycle to see it reflected in stock prices. I suspect another 1-2 months will tell us what sort of headwinds the markets are fighting.


Eugenio,

For currency volatility, JPMorgan has a VXY volatility index for the G7 currencies and a EM-VXY index for emerging market currency volatility.

I don't have Bloomberg, but I understand that the two indices are priced continuously and intra-day updates are reported on Bloomberg with tickers of JPMVXYG7 and JPMVXYEM.

Nick H. said...

Bill, I sell short strangles on the VIX in the last 10-15 mins of the last trading day. I have done quite well with this strategy...until April when the VIX SOQ was a lot lower than the VIX closing price on the last day of trading. Which brings me to my question: can you explain the overnight risk of holding VIX short? What can happen overnight that causes the VIX SOQ to move? And is some of the problem that the SOQ is calculated differently than the $VIX index which we use when trading the options?

Bill Luby said...

Hi Nick,

Good questions about the SOQ. I can think of only two factors off of the top of my head that should have the biggest impact on the VIX SOQ.

The first, of course, is the potential for market moving news before the open. This is associated with any overnight holding and is not specific to the VIX.

The second factor is that the VIX SOQ uses traded prices instead of the midpoint of the bid-ask spread. Quoting the CBOE, "...the VIX SOQ is the only VIX calculation that uses traded prices. Every other reported VIX value uses mid-quote prices of SPX option series. Typically, the theoretical VIX bid/ask spread (i.e., the difference between VIX calculated using bid prices and VIX calculated using ask prices) is 0.8 to 1.2 VIX points. If the VIX SOQ is calculated using predominantly bid prices, or predominantly ask prices, there may be a significant difference between the exercise settlement value for VIX options and the reported VIX values (based on mid-quote prices) on expiration day as well as at the close on the day before expiration." [emphasis is added]

So...if there is significant overnight news, not only will the VIX move, but if trades start hitting all the bids or all the asks as a result, you could see an extra point or more move in the VIX.

I hope this helps.

Cheers,

-Bill

Len Monte said...

With the VIX in the teens, do you believe it is time to short the overall markets? If so, any particular sectors that you find attractive on the short side?

Bill Luby said...

Hi Len,

My current read on the VIX and other volatility indices is only slightly bearish -- not enough compel me to put on significant short positions.

For the moment at least, I'd like to see how much the dollar rallies and whether oil heads back down to new lows before making a decision about shorting particular sectors.

Good trading,

-Bill

John said...

Dear Bill,

I have a question related to trading the VIX. How come the futures prices differ from the spot?

Even though it's not possible to trade the VIX spot, could one not construct a syntetic VIX spot from delta hedged options? If so, wouldn't there be possibilites of arbitrage against the futures?

Great blog by the way!

Bill Luby said...

Hi John,

You may wish to check out an article by Larry Williams from the Dec 2007 issue of Active Trader: The VIX Fix

Cheers and good trading,

-Bill

Tom E. said...

Great thread! Is there a volatility measure for the S&P/TSX index in Canada?

Bill Luby said...

Hi Tom,

The only Canadian volatility index I am aware of is the MVX, which is calculated from current prices of nearby at-the-money options on the iShares of the CDN S&P/TSX 60 Fund (XIU) that are traded on the Montreal Exchange.

I don't know how much Canadian investors follow MVX, but I'd love to hear more from any readers in the know.

Cheers,

-Bill

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