Understanding the Volatility IndeX (VIX)
*Thanks to my good friend and former colleague, Eric Newman, for contributing this article. Eric spent the majority of his career as the Chief Investment Officer at TFS Capital, where he served as co-Portfolio Manager. Eric helped develop and oversaw one of the firm's proprietary trading strategies focused on volatility (VIX).
Everywhere you look, financial commentators love talking about the VIX Index. If you believe what you read, this index seems to have the power to predict the future. It’s very often called a “fear gauge.” It can be a “red flag for the markets.” And apparently it can also be just plain “eerie.” But what is the VIX? And why is everyone so fascinated by it?
Let’s start with the basics. The VIX (or Volatility IndeX) measures how expensive “option” prices are. But what are options and why do we care how expensive they are? Options are simply the right to buy or sell shares of a given stock or stock market index. Imagine someone coming up to you and saying, “Hey, I’ll sell you an “option” to buy Amazon stock at the exact level it’s trading at today. And, you can exercise that right (that option) at any time in the next six months or not exercise it at all. Sounds pretty good, right?
Yes, options have great benefits. In this case, your option ensures that you participate in any upside movement in the price of Amazon stock but don’t participate if it goes down. Suppose you wanted to own Amazon stock, but you are worried that a big decline is coming. If the decline happens, the stock will end up much lower than it is today. Owning an option, rather than the stock itself, allows you to risk less capital while still participating in the gains of the stock. If Amazon goes up, you get the gain, but if it goes down, you only lose the price of the option.
So, what’s an option worth and why do we care?
The real, yet unhelpful, answer is that the option is worth whatever people will pay for it. That’s how the option market works. There are some obvious factors that will make the price higher or lower. For example, people are willing to pay more for an option that they can use over a longer period of time (e.g., one that can be exercised at any time in the next 2 years as compared to one that expires after just 2 weeks).
A second major factor affecting the price of options is the volatility of the stock or stock market index. In other words, if the price of a stock generally fluctuates a great deal, the option would be priced higher relative to a stock that is more stable. When it comes to pricing options, it’s not the actual volatility that matters but, rather, it’s the implied (or predicted) volatility. Not surprisingly, predicted volatility is constantly changing.
At the beginning of this article, you were offered the option to buy Amazon stock at its current price. But there are also options that give you the right to SELL at today’s price. These are called “put options,” and they give you the right (but not the obligation) to sell at a set price over a set period of time (options to buy a security are called “call options”). If the stock crashes, you can use the put option to sell at the option’s fixed (and higher) price thereby avoiding a loss.
This brings us back to the VIX Index. We mentioned above that the VIX measures how expensive options are. Its title as a Fear Index refers to people’s willingness to pay high prices for “put options.” In short, as investors predict or observe volatility, the VIX Index rises. Fear makes you willing to pay up for the safety of a put option.
Investors generally expect the highest volatility following a stock market crash. It’s at this time that the VIX index soars. But in a calmly rising bull market, the VIX is generally very low. Take a look at some actual recent data; in particular, take a look at how the VIX skyrocketed while the S&P 500 Index fell in February and March of 2020:
Why does the VIX spike when the market goes down? When the market is crashing, people are afraid and they generally assume more volatility is coming. And that fear makes them willing to pay a lot more for put option protection.
Commentators and investors love to speculate about the direction of the VIX index. Headlines scream things like “The VIX could be getting ready to spike” which is a roundabout way of predicting the market will fall. Often the VIX begins to rise ahead of a market pull-back and, consequently, a rising VIX leads commentators to conclude that “investors are getting nervous.”
The VIX index is a fun and interesting number to track. Maybe it can show you the “fear” in the market, or maybe not. In either case, we hope you’re now better prepared to join the discussion.