Every so often, especially when markets are extremely volatile, the financial press remarks on the VIX index, which is considered one of the best ‘dread and greed’ indicators in the US market. There is no equivalent in the UK, but of course CFD traders can use other volatility measures such as standard deviation or average right range functions. Nevertheless, knowledge of the VIX is useful in measuring risk in terms of ‘dread’ levels.

The VIX was made as a measure of implied volatility in the US, and followed on from the development of work in the options market relating implied and historic volatilities. It is widely used now as a useful snapshot of market psychology.

Development of the Vix

The first VIX was developed by in a paper by Professor Robert E. Whaley of Duke University. It was presented to the Chicago Board Options Exchange in 1993, and it started with a weighted measure of the implied volatility of eight S&P 100 index “at the money” place (right to sell) and call (right to buy) options. An “at the money” option means that the option chosen gives the right to buy or sell at a level close to or at the underlying market price, and the premium for each option thus reflects the implied volatility of the index.

Ten years later, the CBOE expanded the range of options and based it on the broader S&P 500 index, which gave a more accurate view of future market volatility.

The VIX formula uses a kernel-smoothed (statistically weighted) estimator that takes as inputs current market prices for all “out of the money” (options containing only time value) calls and puts for the next month and second month expirations. From this, an estimation of the implied volatility of a synthetic, “at the money” option on the S&P 500 index with 30 days to expiry is made.

What the VIX level indicates

The VIX is quoted in terms of percentage points and represents in essence the expected movement in the S&P 500 index over the next 30 day period, which is then annualized.

If say the VIX is at 15, this represents an expected annual change of 15% in the index. From this it can be inferred that index option pricing expects the S&P 500 to go up or down 4.33% over the next 30 day period (15% divided by the square root of 12). You can see the similarity to standard deviation measurements here.

So if the S&P 500 stands at 1500, this means that index options are priced with the assumption of a 68% likelihood (one standard deviation) that the 30 day change in the S&P 500 will be less than 64 points up or down.

For this reason, the VIX pricing is different to many other technical indicators, and the rule of thumb is that a VIX level above 30 reflects a large amount of volatility as a result of investor dread or uncertainty. Levels under 20 are generally seen in quieter, less volatile market conditions.

Because the VIX aims to measure market sentiment, it works out how much people are willing to pay to buy options on the stockmarket, and because it is viewed as a measure of ‘dread’ this would usually represent the price of place options to protect against declines.

During very cool periods, the VIX may head down towards around 12, but it is very rare for it to go much lower – there has to be a price for taking an option on market movements but silent the background may seem.

At the other end of the scale, values above 60 have been seen during market panics. What many traders often look for is a sharp reversal in the VIX to indicate or confirm a possible turning point. A VIX price of 60 would mean it is five times more expensive to buy options than in the quietest times (VIX of 12), and these levels do not typically last long.

The VIX can really be traded itself and there are both futures and options on the indicator.

A word of warning

Although the VIX is used as an vital representation of overall sentiment for equity options, this is not strictly right. The VIX, being an index-based implied volatility measurement, has a slightly different dynamic to individual equity option pricing. Occasionally, equity and index options are uncorrelated, and in particular, the VIX is limited to a 30 day period measurement, while for equity options, the most liquidity is usually found between two and six months to expiry.

The other point is that market movements often relate to how much influence ‘flavour of the month’ sectors have on the index. It might be highly volatile in financial stocks, with the current sub-prime crisis a case in point, and if the weighting of these sectors is high, it might influence traders in the pricing of options in other, less volatile sectors.