Volatility Index (VIX)
Lindsay KruepNovember 25, 2018
The Volatility Index (aka VIX), created in the early 1990’s has many different names but is commonly known as the “fear gauge” to those in the investment world. The development of this concept was not created until 1986 by Menachem Brenner, a professor of Banking and Finance Analytics and Dan Galai, a visiting professor of Finance at the same university. It was not until 1992 that the Chicago Board Options Exchange sought out knowledge of Robert Whaley to develop of Volatility Index instrument based on index prices to be used in trading. In 1993 the Volatility Index was officially named “The Chicago Board Option Exchange Volatility Index”. (Wikipedia.com)
The Volatility Index is used to measure the options in the S;P 500 index for a thirty-day lookahead. Since its creation, the index has served as the most reliable indicator of the market. Unfortunately, there is no such thing as a positive volatility as the more uncertainty there is, the risker an investment can be. There is a love-hate relationship between volatility level and stock prices as the higher the volatility level the lower the stock prices. So, why is the Volatility Index a good way to measure the state of the market? The only thing to fear, is fear itself. We always fear the unknown. As investors, this is true statement as the unknown can be very cruel in the finance markets. Since investors are in constant communication with all things banking and investment, it is their job to know what direction the market is going to go. VIX is important for them because daily investors can see which direction the economy is heading. The Volatility Index allows them to gather pertinent information that will guide them to tell clients what stocks to go for, which ones to get out of, or if it is ok to hold tight. The other advice they can offer as a result of this index, is to corporation. It can be a good indicator of if they should hire more people and grow or hold off until things seem to be evening out and growing. The index is crucial in understanding the signals this indicator provides to investors, so they can gather as much data as possible to be able to interpret the direction of the market.
Let’s look at the past and present relationships between the index and stock prices. The past relationship between the index and stock prices are shown below in the chart. Mainly you can see that in 2008 during the financial crisis, the “fear” was at an all time high, with stock prices dropping drastically in comparison to what the state of the economy was before the drop. Before 2008, the VIX never got any higher than 50, it reached to 80 in November 2008.
The 2008 Crisis is the worst since the 1930’s in the Great Depression. During this time, we were in threat of a total global financial collapse. As you can see below in the present chart that represents the relationship between VIX and the S;P, we are no where near the highs and lows from 10 years ago. While there seem to be spikes in the numbers throughout the years, the magnitude is not nearly as great. Confidence is up, and the economy is stable. Investors are confident in the direction of the market, therefore increase in spending and investments is remaining steady. (Big Trends.com, Valuewalk.com)
There has been an evolution of the VIX since it was started back in 1993. At the start the volatility was measured on eight S;P 100 options. Fast forward to the present and now there is hundreds that are measured. There is also not just the standard VIX index, but smaller similar indexes. To name a few, there is the CBOE Short Term Volatility Index which shows a 9-day expected volatility of the S;P 500, then there is a 3 month and 6-month index as well. There are also indexes that measure the NASDAQ100 market. Below is a list from the CBOE website showing the most popular within the S;P.
The method of measuring VIX has also changed from the original ideal. Currently, there are two methods in which to measure the index. One involves calculating on historical prices over a pinpointed time frame. The data used in the calculations include the mean, variance and standard deviation on a price. This is known as the “standard deviation” method and is the method that is based on mostly assumptions. Critics of this method say this may not be a good indicator of volatility because for that reason (Investopedia). The second method entails gathering its option price, or what is known as the Black-Scholes method. This involves derivatives which are instruments where its price is dependent on the likelihood of a particular stock price reaching a certain price level. This method as well faces criticism for having so many variables associated with it, mainly because this way does not forecast the future path of an option. Either way, both methods are not one hundred percent accurate, but they are both reliable ways to measure the volatility with confidence. Specifically, the first method of using standard deviation would be calculated as below with the following formula (shown in excel):
Taken from Investopedia.com, this is showing a 10-day analysis period of McDonalds. The calculation will take the closing price difference to get the standard deviation. As you can see, the formula is straightforward and simplistic.
The second method of calculating using the Black-Scholes method is shown below:
Assume the value of a call option is $4.50 when the stock price is $80.00, strike price is $78.00, risk-free rate is 0.25%, and the time to expiration is one day. Since this method involves a lot of assumption and backing into, start with an implied volatility of 0.4. This will give you a value of $4.13 which is too low. Since call options are based on increasing function, it needs to be higher. Next you can try bumping it up to 0.6, which is $4.37 which is too high. If you were to go down to 0.5, this would be at $4.20 which is ideal. There are five factors that come in to place in order to use this method. They include the market price of the option, the underlying stock price, the strike price, time to expire date and the risk- free interest rate. As you see from the steps above, and all that goes into it, it is no wonder why this is not the favored method to calculate volatility. (Thirdway.org)
Now that you we have been given the ways to calculate the VIX, what do the results mean, other than numbers at the end of a calculation? Briefly earlier it was touched on how the index works, but not how to interpret it. When the VIX is high, that means investors are running scared under the assumption that the market is going in a downward direction. A concerning VIX would be up around thirty and above. VIX values twenty and under are good indictor that the market is stable and there are currently no stress periods in the market. Now, with all that said, to say that there are “good” and “bad” numbers is a little misleading as VIX values have norms just like anything else. So, let’s assume there was a year of high values, averaging in the mid to high forties. Then it starts to level out to around mid-twenties. To say thirty-five would be good, is not necessarily great, but it is the norm for what the trend has been. On the flip side, it can be said for when the value is low. Low is also open to interpretation depending upon where the norms have been. Since the VIX is a thirty day look ahead of the what the market is expected to do, investors are quick to make a move knowing how fast the VIX can also move and the negative impact that it can bring to equities. Taken from the CBOE website as of today, you can see as of November 23rd, 2018 it closed at 20.80 and opened at 21.23. If I were an investor, interpreting this current data, this would show me that the market is stable and there is no cause for alarm. Investments are strong and there is no indication of rising fear in the market.
The question of if you can buy or trade on Volatility Index is brought up amongst the new investors of the world. There is a common misconception that it can be purchased. The answer is no, since the index is just a measuring tool. However, there are different ways that you can invest through VIX. Traders can invest through futures, options, and ETF Investments. (Fool Investing.com) It is recommended though, to not invest long term in VIX index funds due to the poor relationship between the VIX and its frequent ups and downs. It is also not recommended to invest on VIX unless you are a veteran trader since it is not like the stock market. VIX will always see a decline over time, therefore seeing lower returns over a long period of time. There are also several rules and regulations that may or may not apply in the stock market world when dealing with the Volatility Index. According to Fool Investing.com, it only closes/expires on a certain day of the week and certain times of the day, various trading level options, calendar spreads are not allowed, and VIX futures act as if they were options (meaning the prices do not track with the VIX, so you will not be able to cash in if the market goes good or get out of the market goes bad). Early on a chart of a few popular VIX Indexes was provided to you. The below lists a few of the most successful out there:
iPath S&P 500 VIX Short-Term Futures ETN – VXX – This is the most popular and biggest in the index. Its inception was January 29th, 2009 and managed by Barclays Capital Inc. It is known to be riskier than others since there is no protection on principle. This is not recommended for all investors. Closing averages within the last thirty days has been in the high $30 range with a return rate of 34% (Yahoo. Finance.com) Just like any of the indexes you want to get in and out fast, as this is not a good long-term investment. Below is the iPath’s historical performance. (Fool Investing.com)
ProShares VIX Short-Term Futures ETF – VIXY – This one is also popular for those wanting to invest through VIX. ProShares currently is holding in the lower $40’s range with a 42.86% return. This is also not ideal for the amateur trader as this is a riskier fund as well. Below is the historical performance for the ProShares VIX taken from the Nasdaq site as of today.
Investors underestimate the danger in getting involved with volatility funds as the risk of losing everything is probable. Not only is the risk there to lose everything but these types of funds do not give much forgiveness when it comes to the change in market models which can drastically alter the way the funds operate.
Criticism exists with the Volatility Index even though history has proven that the data has been reliable for the investment world. The reasoning for the hard feelings is due to the heavy “assumption” methods used to measure volatility, even though the methodology itself is not questioned. An article from the Chicago Business Journal reads that “CBOE global markets is starting to react to a growing chorus of criticism related to its VIX Volatility Index”. This comes as a result of how poorly stocks have performed, with some speculations of manipulation of the index. The CEO has since reassured claiming that there is no foul play and that the VIX is still working as it was designed. (ChicagoBusiness.com). In its defense, if there is more education and understanding of how this works, the less misunderstandings there will be, thus creating less misinterpretations about what results the index is producing for these investors and traders. When the market is good, VIX seems to be the hero, but when the market is bad, VIX seems to take the fall, hence the love/hate relationship that was mentioned at the start of the paper.
In conclusion, since its ideology was created back in the late 1980’s and then adapted back in the early 1990’s, VIX has been through some growing pains, and has evolved with time. Throughout its life though, VIX has been the most reliable. It has earned its place as being the “gauge of fear” amongst investors. It was never designed to be the end all and be all future market predictions, but simply a means to track how well or bad the market is expected to do in the near future using calculations made up of mainly assumptions. There will never be a bulletproof method that enables us to predict the future. The Volatility Index is as close as we can get in our ability to “see through the crystal ball”, because if everyone had a crystal ball, there would be no need for the Volatility Index.