Volatility is the antithesis of stability and is usually considered bad for stocks. Moreover, it doesn’t matter if volatility breeds uncertainty or if uncertainty fosters volatility; stock prices react poorly to both. Volatility also tends to be higher during a bear market than when stocks are rising. The importance of volatility has played a key role in the development of what we know as the VIX.

In this article, the first of two, we’ll discuss the background of the VIX, discover how it works, look at a few of its applications, and explore its potential to warn investors of an impending stock market correction. 

History

The VIX was created by Robert Whaley, a Professor at Vanderbilt University. Introduced in 1993 by the Chicago Board Options Exchange (CBOE), the VIX is widely considered to be the premier measure of stock market volatility. It is also commonly known as the fear index.

Originally, the VIX was based on options data derived from the companies included in the S&P 100 Index. However, in 2004, the CBOE replaced the S&P 100 with the broader S&P 500 Index. The VIX was originally used to measure the volatility of the broader stock market. Today, it has been expanded to include a number of additional investments such as ETFs, individual stocks, commodities and more.

How the VIX Works

Although the specific formula behind the calculation of the VIX is quite in depth and beyond the scope of this article, we can still glean a general understanding of its methodology. For example, a stock index is calculated using the price data of its underlying securities. Each index will then incorporate its own formula to determine the level of the index.

The VIX, on the other hand, uses options data in lieu of stock prices. The price of each option is a reflection of multiple factors, including the market’s expectation of future volatility. Chris Tsiolis, Senior of Option Monster in Chicago puts it succinctly: “An increase in volatility will cause an increase in the price of an option.”

To expand on this, higher volatility is a reflection of greater uncertainty which causes options prices to rise. This results in an increase in the VIX. 

Investors consider the VIX to be a valuable resource for gauging short-term market risk. As mentioned, the VIX uses real-time options price data which, according to the CBOE, is “designed to reflect investors’ consensus view of future (30-day) expected stock market volatility.” Therefore, a rising VIX is a signal that stock market volatility is expected to increase during the subsequent 30-day period. Conversely, when the VIX trends lower, market volatility is expected to subside.

Observations From the Data

The subject of the VIX raises many issues, including the relationship between the VIX and stock prices and whether the VIX holds any predictive value. In my mind, this latter is the chief among all VIX questions. Before we explore these in more depth, let’s take a brief look at the following chart.

The chart contains data for the VIX and the S&P 500 Index from January 1, 2005 through March 2, 2015. I have labeled 12 points along the VIX line which are marked A-L. I have also divided the chart into five phases which I’ve labeled P-1 to P-5. We will discuss these in a moment. First, let’s explore the relationship between stock prices and the VIX. 

Relationship of the VIX and Stock Prices

Because of the close relationship between the price of an option and the price of the actual stock, the VIX should provide an accurate measure of future volatility. In the chart above, each point labeled corresponds to a spike in the VIX. Notice that each time the VIX spiked, the S&P 500 declined. This indicates that the VIX and the S&P 500 have a very strong tendency to move in opposite directions. This is confirmed by the correlation between the two, which is -0.57. I suspect this negative correlation is much stronger when the VIX spikes as opposed to when it falls. 

Does the VIX Provide an Early Warning Signal?

Discovering a tool which can identify a stock market correction, in advance or in the early days of the correction, is akin to finding the Holy Grail of investing. Can the VIX forewarn investors of an impending downturn?

To analyze this, I divided the chart into five phases marked P-1 through P-5. First, a few observations are warranted. The middle phase (P-3) is the period which experienced the greatest volatility. In fact, the VIX hit its all-time high of 80.86 on November 20, 2008 which was during P-3. To gain a more thorough understanding, let’s refer to the following table.

The table includes relevant information for each phase, including the time period and the high, low, and average VIX. For example, P-1 began on 1/1/2005 and ended on 2/26/2007. During this phase, the VIX averaged 12.67, ranging from a high of 23.81 to a low of 9.89. Using the information in the table we can make a few observations. 

First, the average VIX during P-2 was nearly 63% greater than the average VIX during P-1 (ex: 20.65 versus 12.67). Similarly, the average VIX during P-3 was a staggering 122% higher than its average during P-2 (ex: 45.82 versus 20.65). The point? There was a substantial rise in the average VIX leading up to the market crash. But was it enough to forewarn investors? Let’s examine this using the closing values of the S&P 500. 

The index reached a record high of 1565.15 on October 9, 2007 during P-2. By the end of P-2, slightly over 10 months later, the index had fallen to 1282.83. This represents a decline of 18.04%. Although this is significant, the index was not in official bear market territory….yet. The worst was still to come. From the end of P-2 until the index finally bottomed on March 9, 2009, the S&P 500 lost an additional 47.26%, for a total loss of 56.78%. Did the VIX provide an early warning? Were the lights flashing red? Let’s take another look at the chart.

Let’s compare each phase. Note how the VIX was very calm in P-1 with only one exception (point A). The average of the VIX during P-1 (i.e. 12.67) was much lower than its long-term historical average of 19.61. In P-2, the VIX spiked multiple times, represented by points B-G. The spikes in P-2 are reminiscent of tremors prior to an earthquake.

In P-3, the worst period for volatility, there were several spikes but I only labeled one (H). Following P-3, we can see how P-4 was also elevated and was similar to P-2. We can also see how P-5 was quite low and very similar to P-1. In fact, upon closer inspection, it is interesting to see how P-5 and P-1 only have one spike and how closely they resemble each other. Are we heading into another P-2 period? 

In the phases farthest from center (i.e., P-1 and P-5), the average VIX is well below its historical average. The phases adjacent to the middle phase (P-2 and P-4) are alike in that they are both elevated. P-4 is the period of the flash crash which occurred in May 2010 (point I) and the stock market correction in 2011 (point J). 

Conclusion

We’ve covered the VIX from several angles. We learned how it works, discussed its relationship to the broader stock market and saw how it fluctuated in the months leading up to the worst period of volatility in the financial markets since the Great Depression. Did the VIX provide a warning?

Moving forward, I believe the VIX will become more widely utilized. In the second article in this Under the Hood series, we’ll look at some ETFs that are attempting to track the VIX.

We’ll see how well they’re doing and discuss the risks involved in these types of investments.