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.
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