The VIX explained

March 27, 2020

When things get ugly on Wall Street, the financial media seems to focus much a lot more on the VIX.  So what is that anyways and what does it mean?

 

The CBOE VIX (Chicago Board Options Exchange Volatility Index) measures the short term volatility of S&P 500 index price.1  In layman’s terms – it is a guide for how big the swings in the S&P 500 price are currently projected to be within the next year.  It is generally thought that a VIX score above 30 indicates a volatile market and a reading of under 20 indicates a stable market.

As you can imagine, projecting the low and the high over the next year doesn’t do the day traders much good, so they seek to narrow down the scope with some mathematical assumptions.  Below is a very crude (rounded) calculation on how to turn the number you see on the screen into even shorter term information. 

Again there are a lot of math calculations behind this, but to roughly estimate, with 90% probability, the range of the S&P 500 over the next 30 days:

The equation2 is:

S&P Price +/- ( VIX / 211 ) * S&P Price

So let’s say for example the S&P 500 is at 2400 and the VIX is at 50.

2400 +/- ( 50 / 211 ) * 2400

2400 +/- 569

So at those levels, there is a 90% chance that the S&P 500 would stay between 1831 and 2969 over the next 30 days.  That's quite a range and to realize the VIX has been even higher in recent times is eye opening.  Note this is measuring movement within 30 days, not at the end of 30 days.

 

You might be in the camp that the above is too much work to figure out, so here’s a few more general thoughts.

As a measure of true volatility, the VIX should be equally high whether or not markets are crashing or running away upwards.  A 5% up day should have the same effect on the VIX as a 5% down day, mathematically speaking.  However that really never seems to be the case.  Most times, when the VIX is high, markets are going down fast.    When markets are going up, even by the same delta as when going down, the VIX is generally at a comparatively lower level. 

The reason for this is quite simple – fear vs. greed.  In a fearful market climate, panic sets in and the bears sell very quickly to avoid loss.  In a greedy market climate, the bulls seem to methodically add to their holdings over time.  In short, Fear is more volatile than Greed.


Hope you all are healthy and safe during these volatile times.  (See what I did there?)

 

Ken

 

Sources –

1 – Investopedia

2 - Seeking Alpha – if you want to see the more precise calculation numbers you can find them here

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