It has an unwieldy name: the CBOE Volatility Index. It’s usually referred to by its shorthand and ticker: VIX. It’s obscure enough to not be a household name, and commonplace enough to make a frequent presence in the mainstream financial press. Many claim to understand it; few actually do.
What is the VIX, exactly? Investopedia defines it this way:
“VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the ‘investor fear gauge.’”
Okay, so it’s related to the S&P 500 and options on that index.
Wikipedia has a clearer definition, although it’s not very precise:
“Put simply, it is a mathematical measure of how much the market thinks the S&P 500 Index option, or SPX, will fluctuate over the next 12 months, based upon an analysis of the difference between current SPX put and call option prices.
Although the VIX isn’t expressed as a percentage, it should be understood as one. A VIX of 22 translates to implied volatility of 22% on the SPX. This means that the index has a 66.7% probability (that being one standard deviation, statistically speaking) of trading within a range 22% higher than — or lower than — its current level, over the next year.
The VIX rises when put option buying increases; and falls when call buying activity is more robust. (Note: A put option gives the purchaser the right — but not the obligation — to sell a security for a specified price at a certain time. A call option is a right to buy the same.)
For contrarians, low readings on the VIX are bearish, while high readings are bullish.”
So the VIX can be used as an indicator of market expectations. A low VIX means the market is bullish (making contrarians bearish), and vice versa. That’s how the VIX is often used, but what is it, exactly? Going further into Wikipedia, we get a more detailed and technical explanation:
“The VIX is quoted in percentage points and represents the expected range of movement in the S&P 500 index over the next year, at a 68% confidence level (i.e. one standard deviation of the normal probability curve). For example, if the VIX is 15, this represents an expected annualized change, with a 68% probability, of less than 15% up or down. One can calculate the expected volatility range for a single month from this figure by dividing the VIX figure of 15 not by 12, but by √12 which would imply a range of +/- 4.33% over the next 30-day period. Similarly, expected volatility for a week would be 15 divided by √52, or +/- 2.08%.
The price of call and put options can be used to calculate implied volatility, because volatility is one of the factors used to calculate the value of these options. Higher (or lower) volatility of the underlying security makes an option more (or less) valuable, because there is a greater (or smaller) probability that the option will expire in the money (i.e., with a market value above zero). Thus, a higher option price implies greater volatility, other things being equal.”
Much more detailed but somewhat complicated. Still, after reading these three definitions we can come to a pretty clear understanding; the VIX measures market expectations of future returns on the S&P 500, with low ratings being bullish and high ratings being bearish. However, since it is a statistical measurement of volatility (i.e. the amount of change within the measured phenomenon, here the S&P 500), volatility also measures the rate of upward change too. So wouldn’t a bull market have a high VIX, as well?
Not necessarily, for one simple reason: bear markets fall very fast, but bull markets go up much more slowly. That makes the VIX skew naturally towards measuring bearishness much more than bullishness, and that makes it a very useful tool for understanding the market’s expectations.
Why am I drawing your attention to this now? The VIX took a rare dip below 10 earlier this month and remains below 11; that is just a little more than half its historical average number. Yet the hysteria, especially in the United States, is deafening; James Comey’s firing, North Korea missile tests, high valuations, squeezed U.S. workers, higher Fed rate targets . . . it seems like a bearish storm. So why is the market so bullish?
The answer is again quite simple: the market is comprised of a number of mostly rational investors seeking profits above all else. Investors set aside their personal, political, and ideological beliefs (for the most part) in the pursuit of profit. And Comey’s firing, North Korea’s missile tests, and squeezed U.S. workers don’t necessarily indicate danger to the stock market.
Or do they? Is there, in fact, a rational, logical argument that these things are existential threats to the bull market? If so, they need to be demonstrated quantitatively. Data needs to be collected, compiled, and formulated into a narrative that explains why investors need to worry. No one has done that yet, at least not convincingly, which is why the market is remaining calm and complacent.
For individual analysts, now is the time either to develop an alternative narrative based on data or understand why headlines, political noise, and non-data developments are a distraction from the business of making money in the market.