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The VIX -Understanding the Misunderstood.

Let’s take a look at Chicago Board of Options Exchange Volatility Index, which is commonly referred to as the VIX index. This seems to be Everybody and their Grandmother’s favorite Technical Indicator.

There are many misunderstood aspects of Technical Analysis, and the VIX is certainly one of them. In my view, analysis of this indicator in order to predict future market movements is a useless waste of time. All it shows is a current snapshot of the market. It is essentially like trying to predict who is going to win a race by standing at the finish line and seeing who crosses first. Indicators need to be predictive and this one isn’t.

First of all, the VIX is most often cited as measuring the volatility of the market. But this is wrong! The VIX is actually a measure of IMPLIED volatility...it does not measure the ACTUAL volatility. So just what exactly is Implied Volatility? It is a measure of the EXPECTED volatility. In other words, it is an ESTIMATE of what the Market expects the volatility to be. (And as we all know, expectations and reality are often quite different.)

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The implied volatility number is derived from the Black-Scholes formula. Black-Scholes is used to determine the CORRECT price of an option, as opposed to the MARKET price of the option. If the difference is large enough, traders try to take advantage of it by taking a position in the option and hoping it will revert to the ‘correct’ price. The formula suggests that the price of an option is basically a function of five parameters-

1) The difference between the price of the underlying security and the strike price of the option.

2) The price of the option.

3) The time to expiration.

4) Interest rates.

5) The VOLATILITY of the underlying security.

We know what the first four are so the unknown fifth parameter- the volatility- can be calculated.

The VIX index measures the implied volatility of the S&P 500 index and it is derived from S&P 500 index options. Roughly speaking, it shows what the market thinks the annualized volatility will be in percentage terms. For example, it the VIX is at 25 it means that the market expects 25% annualized change over the next 30 days.

Now pay attention. This is the key to the whole VIX issue. When markets become more volatile, then by definition options will become more valuable. This is simply because the greater the volatility of an option, the higher the odds that it will expire in the money. So traders are willing to pay higher premiums to enter and exit positions.

That’s why when the market sells off dramatically the VIX index soars. Traders became extremely aggressive in their trading tactics which means they were willing to pay high premiums to enter or exit positions. That’s why this index is referred to as the “FEAR INDEX”. But this is yet another misunderstanding! If everyone was euphoric and thought that the markets were about to soar like an eagle, traders would also be willing to pay higher premiums to enter bullish positions so the VIX Index would soar as well. I suppose that at this point it would probably be incorrectly referred to as the “HOPE INDEX” …

The bottom line is due to the construction methodology of the index; it is a coincidental indicator. It is not predictive.

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This chart illustrates the VIX at the three most important inflection points in the Equity Markets from 2007 – 2010. 1) When Equities

peaked in October 2007. 2) Just before they collapsed in September 2008. 3) When Equities bottomed in March 2009. I have also

pointed out where the VIX was just before Equities peaked in April before a large selloff began. (fyi…it says ‘current because this chart was originally

made in the summer of 2010) I didn’t see anything that would have given me a signal at those times, and even with the benefit of hindsight I

still don’t see anything…

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Laszlo Birinyi, the legendary market analyst, took a look at the VIX. Here is a quote from Buinessweek in March of 2010 which supports what I have been saying for years:

“The VIX is alleged to be an indicative indicator and has become a staple of analysts and journalists alike. We respectfully disagree and ultimately conclude it is a measure of current volatility with little or no predictive or indicative value regarding the course of the market. The VIX is a coincidental indicator,” Birinyi wrote. “It details, perhaps better than other measures, the volatility of the market today but not tomorrow or the day after.”

Here we have the S&P 500 plotted against the VIX index. You can clearly see that dramatic movements in the VIX occur AT THE SAME TIME as dramatic movements in the S&P 500 do. It is coincidental…not predictive.

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To summarize:

Many analysts and journalists routinely talk about the VIX, but few have any idea of just what exactly it is that

they are talking about.

Don’t get too caught up with analyzing the VIX or any other ‘Indicator of the Day’.

If too many people are watching an indicator, it will lose its value.

I do not understand the obsession with this indicator. Although it may have some use as a trading vehicle,

analysis of the VIX as a way to predict future price movements is essentially a waste of time.

Due to the construction methodology, the VIX is a COINCIDENTIAL indicator. It is NOT PREDICTIVE. It

moves at the SAME TIME as the underlying markets. NOT BEFORE them.

Don’t waste your time worrying about things that the media or most analysts don’t understand. It will only

confuse you.

Worry about things that actually do affect the direction of the markets, like major trends and levels of supply

and demand.