5MF Issue 11: Understanding VIX - The Volatility Index

Analysts often refer to the VIX as “the fear index” or “the fear gauge”, but how does an index quantify consumer sentiment, and what can we learn from it?

As the COVID-19 virus threatened to derail the world economy in mid-March of 2020, a measure colloquially known as the “fear index” jumped from the 20s to an all-time high of 82.69. For the rest of the year, VIX—the volatility index created by the Chicago Board Options Exchange (CBOE)—settled to an average of 28. Now, experts at JPMorgan expect VIX, to decline in 2021 to around the 17 level.

While you might be excused for taking predictions like these with a grain of salt amidst such unpredictable times, understanding VIX is arguably more important than ever.

Measuring Fear In the Market

Put simply, VIX tracks trader sentiment in the stock market, predicting potential volatility. When trader behavior indicates fear, the index goes up. When it indicates confidence, VIX goes down. Impressively, the index calculates this all in real-time.

But how can an index measure fear or confidence? After all, it’s not like the CBOE surveys traders every few seconds. The magic lies in a complex equation based on S&P 500 index (SPX) options trading.

As a widely accepted indicator of overall stock market performance, the S&P 500 is the perfect data source for this calculation. One strategy for traders who anticipate a market drop is to buy SPX puts—the option to sell at a future date—at a lower price lower than current levels. Conversely, traders who are bullish on the market can buy calls—the option to buy at a future date—at a higher price than the market is trading today. 

By basing the VIX equation on SPX options trading, the index paints a fairly accurate picture of what traders think the market will do in the near future. As a result, it’s regarded as the standard for monitoring short-term market volatility.

A quick lesson on options contracts, or “options” for short:
Investors can trade two types of options, calls and puts. For a call option, a trader buys in and sets a buying “strike price” and an expiration date. For example, one may pay $100 for the option to buy 100 shares of SPY at $350 (the strike price) before June 1st.
At any point before expiration, the trader can buy the option at the strike price—even if the SPY value is higher at the time, say $360 (a $1,000 return, less the $100 option price). Call options are popular with investors who expect higher prices in the near future.

For a put option, the trader still buys in with a strike price and an expiration date. However, a put means that the trader can sell the option at the strike price at any point before expiration. (i.e. the option to sell SPY at $350 even if its value at the moment is $330). This usually means that they anticipate lower prices in the near future.

Understanding the Numbers

VIX uses data about SPX calls and puts that are set to expire in the next 23-37 days to calculate sentiment about the next 30 days in real-time. Lots of calls? Traders are fearful, and the volatility index goes up. Lots of puts? Traders are feeling confident, and VIX goes down.

The VIX often mirrors the SPX (one tends to be up while the other is down), but not dollar-for-dollar. The volatility index measures attitudes, not price, so the number produced by the calculation isn’t a dollar amount. 

The equation produces solutions that range from 1-100, and these are understood as percentages which are based on historical volatility. Thus, a VIX of 11 means the SPX is 11% volatile compared to historical averages.

A VIX value above 20 is typically considered “elevated”. In 2020, VIX rose above 20 in late February, reaching record levels in March, and never returned to pre-COVID levels. As of January 2021, it’s still hovering around 25.

What We Can Learn From the VIX

Investors, analysts, and portfolio managers use the VIX as one of many tools for understanding and investing in the stock market. Many refer to it while analyzing the market, while others invest indirectly in the VIX itself through futures, ETFs, or ETNs to hedge more traditional stock investments.

For banks, however, the index provides something a little different.

When volatility is high, banks may make money from fees on increased trading. However, they pay for it in other ways. A falling market means increased risk, decreased consumer spending, and hesitant funders. As a result, their own stocks tend to suffer in periods of volatility. 

This is why JPMorgan’s prediction brings hope for banks after a year of elevated VIX. A decline in volatility invites hedge fund investment in equities. According to the bank’s experts, a “combined $550 billion in equity inflows could come from systematic funds and hedge funds in 2021 as they buy stocks.”

With predictions like that, it’s easy to see why the VIX is one index that banks want to see fall.

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