More and more investors are using options prices offered up by the Chicago Board Options Exchange's Volatility Index, or VIX, to help determine market direction. Here we'll look at what VIX is, how it is developed and how it is useful to investors.
What Is the VIX?
The VIX is one of the investment industries most widely accepted methods to gauge stock market volatility. The first version of this index was developed by the CBOE in 1993 and was calculated by taking the weighted average of implied volatility for the Standard and Poor's 100 Index (OEX) calls and puts. However, in Sept 2003 they revised it to give a more accurate depiction of broad market volatility. In essence, VIX is a gauge of investors' confidence or non-confidence in market conditions.
It is important to understand that the VIX does not measure the volatility of a single issue or option instrument, but uses a wide range of strike prices of various calls and puts that are all based on the S&P 500. What is formed is a more accurate measure of the markets expectation of near-term volatility.
Determining Market Direction
Incorporating a wide range of S&P 500 index options truly makes this index a cross-section of investor sentiment. The VIX has an inverse relationship to the market, and a chart of the indicator will usually be shown with the scale inverted to show the low readings at the top and high readings at the bottom.
A low VIX, a range of 20 to 25, indicates traders have become somewhat uninterested in the market and generally indicates a sell-off. The value of VIX increases as the market goes down and decreases when the market moves in an upward direction. A rising stock market is seen as less risky and a declining stock market more risky. The higher the perceived risk in stocks, the higher the implied volatility and the more expensive the associated options, especially puts. Hence, implied volatility is not about the size of the price swings, but rather the implied risk associated with the stock market. When the market declines, the demand for puts usually increases. Increased demand means higher put prices and higher implied volatilities.
For contrarians, comparing VIX action with that of the market can yield good clues on future direction or duration of a move. The further VIX increases in value, the more panic there is in the market. The further VIX decreases in value, the more complacency there is in the market. As a measure of complacency and panic, VIX is often used as a contrarian indicator. Prolonged and/or extremely low VIX readings indicate a high degree of complacency and are generally regarded at bearish. Some contrarians view readings below 20 as excessively bearish. Conversely, prolonged and/or extremely high VIX readings indicate a high degree or anxiety or even panic among options traders and are regarded at bullish. High VIX readings usually occur after an extended or sharp decline and sentiment is still quite bearish. Some contrarians view readings above 30 as bullish.
Conflicting signals between VIX and the market can yield sentiment clues for the short term, also. Overly bullish sentiment or complacency is regarded as bearish by contrarians. On the other hand, overly bearish sentiment or panic is regarded as bullish. If the market declines sharply and VIX remains unchanged or decreases in value (towards complacency), it could indicate that the decline has further to go. Contrarians might take the view that there is still not enough bearishness or panic in the market to warrant a bottom. If the market advances sharply and VIX increases in value (towards panic), it could indicate that the advance has further to go. Contrarians might take the view that there is not enough bullishness or complacency to warrant a top.
In this chart of the VIX indicator for the 20 months preceding Aug 2002, you can see by the three red down arrows that the market sentiment was bearish and implied that volatility was extremely high. A black up-arrow shows the market turning somewhat more bullish and less volatile in Apr 2002. Knowing the events of the preceding six months, it is not surprising that the VIX would move sharply back to a bearish sentiment not seen since the disaster of Sept 11, 2001. You can see that in the last few weeks shown on the chart that the sentiment wanted to turn a little more bullish but there continued to be a bearish hold on the markets.
This is an indicator that is rarely out of step when it is viewed from market directions on a broad scale and will more than likely help investors see the bottom forming and the next strong bull market develop.
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