The VIX FAQ
One of the most misunderstood financial
measurements that exists today is the CBOE Volatility Index. It has been
called many things, and it seems that when analysis is done on the
name, it is more a confirmation of what the viewer wants to see. Most of
this analysis is done without a true understanding of what the VIX is
and how to trade it. So with that in mind, let's have a quick primer on
the VIX.
What is the VIX?
The
VIX is a measure of near term volatility. This measure is derived from
the premium seen in SPX options. So that means it is simply a rough
measure of supply and demand for equity options 30-days out.
How
is the VIX Calculated?
You asked for it…
Yeah,
I know.No, really, how is the VIX
calculated?
First it sums up premiums on out of the
money options on the SPX. It doesn't take into account options that
have less than a week to expire because they have their own voodoo. You
also normalize it to a 30-day period doing some fancy averaging and
weighting.
What does the VIX tell us?
It
gives you the expectation of absolute movement as indicated through
option premiums. This is detrended data.
Here's how you
calculate it. Take the current VIX reading (say 20%) and divide it by
the square root of 12 (3.46) and you get the expected absolute movement
of the market within a 1 month period.
If you want to look at a
single day's expected movement, then you divide the VIX by the square
root of the number of trading days (252) to get your expected daily
range.
It's that precise?
No.
The VIX is a statistic, so there are probabilities involved, and it
goes back to lognormal distributions and how options are priced.
Essentially, you will expect SPX price movement to stay within the range
dictated by the vix about 2/3 of the time (68%).
Isn't
the VIX Bearish?
Kind of, but it's a chicken and
egg argument. Market sells off so you see higher premiums as investors
are willing to pay up for more insurance. You don't see the tail wagging
the dog. There is a negative correlation between the VIX and SPX of
something like -.80
How do I trade the VIX?
You
can't.
Well, you can trade VIX options! Got
you there, you smug SOB.VIX options are not based
on the spot VIX. They are based on a forward value determined by the
market. They are NOT based on VIX futures, although you can use VIX
futures as a reasonable guideline.
Can you do
technical analysis on the VIX?
Define TA.
Traditional technical analysis seeks to quantify supply and demand in a
particular instrument. To have actual supply and demand the instrument
has to be tradeable. Since the VIX isn't tradeable, you can't apply
traditional TA.
Now there is supply and demand for options, but
that behaves much differently than asset prices. For example, there is
much more mean reversion (sans 2008) that occurs. So it's complicated.
So
Mr. Smarty Pants, what can we do with the VIX?I
look at a few things. First, we look at the relationship between the VIX
and the actual (realized) volatility in the market. At the time of this
writing the VIX was 18-ish and at the lower end of its range, but that
doesn't mean it's high, because the realized vol was single digits.I
also put eyeball the trend using moving averages, and I also use
bollinger bands to get a feel of how extended the rubber band is.
You
can use the VIX especially when you're looking for when the market
perception of risk is a little too high or low. You can then structure
option trades in equities to take advantage of that fact.
Where
else can I learn about the VIX?
Check out the
sources below. And sometime I'll do a webinar discussing the VIX and
other volatility products if there's enough demand for it.
Exactly
who are you?
My name's Steve, I trade options, and
I blog at investingwithoptions.com
Sources:
www.cboe.com/VIX
www.cboe.com/micro/VIX/vixwhite.pdf -VIX
Whitepaper
