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October 24, 2016 at 08:00 PM
In preparation for a potentially close U.S. presidential election it may be beneficial to review how the CBOE Volatility Index (VIX) played out prior to the Brexit vote as well as what this measurement means. On June 6, 18 days prior to the Brexit vote, the VIX closed at 13.65, a relatively low reading for volatility. Within a week, the VIX would reach 21.00, and by voting day on June 24 it had reached 25.76 — that’s a 90% jump in value in just over two weeks. Market participants who were watching VIX knew something big may be coming.
In contrast, the S&P 500 was relatively flat in the weeks preceding the Brexit vote. If market participants were simply watching the S&P 500, they would have had no idea how risky the future may be.
Given this example, it’s no surprise that the VIX has become a bit of a rock star. It is one of the main scrolling tickers on CNBC. It has the second most active options activity, only behind the S&P 500 Index. In addition, 20 ETFs track it (top five tickers: VXX,XIV,SVXY, UVXY andTVIX), with total AUM of $4.5 billion and daily volume of around $135 million.
Why the popularity? One answer is because the VIX is a very efficient way — in fact, one of the only ways — to understand perceived market volatility at any given moment.
Stepping back for a moment, let’s recap the definition of volatility: It is a measurement of dispersion of results around the mean for whatever you may be measuring — investment returns, archery practice, your dating life, etc. The higher the volatility, the more unpredictable results are. Conversely, low volatility suggests a tighter band of results around the mean and more predictable results.
Volatility provides a good measurement of potential risk and is a powerful tool to use in making decisions. As a general rule, people want predictable, controlled outcomes (a tendency known as risk aversion) in important areas of life. An outcome that is perceived to be relatively volatile and thus less predictable — such as investing in space flights to the moon or a vacation spot with widely varying weather — has to offer significant rewards for the trouble, such as a chance to change human history or at least a free breakfast buffet with all-you-can-drink mimosas.
How Does One Measure Volatility?
That depends if one is talking about historical volatility or future expected volatility (Future expected volatility is known as implied volatility in the finance industry).
In calculating historical volatility, one looks at the average of all results (for whatever time period is being evaluated) and then compares how much each result differs from the average of all results — the more each result differs from the average, the greater the volatility for the population.
For those who find history boring and instead want to see into the future, implied volatility is the way to go: It reflects the expected future dispersion of results around the future average. Implied volatility is a variable used in options pricing, and therefore implied volatility can be reverse calculated from the market price of an option. All else being equal, the higher the price of an option, the greater the implied volatility the market is assuming for that security.
Illustrating Volatility
Here’s an illustration using Apple (AAPL) stock. Let’s say the expected average return over the next year is 5%, and the current implied volatility is 10%. Then expectations are that 68% of the time (for those statistics buffs out there, one standard deviation, assuming a normal distribution of returns) AAPL stock would generate returns of between -5% and +15% over the next year. Now imagine that instead of implied volatility being 10%, it was 30%. In that scenario, 68% of the time AAPL would return between -25% and +35% in a year. That’s quite a range.
