The VIX Index is widely reported and analysed in the world of trading but so much of what is written about it is either misguided or misinterpreted. Sometimes this is done for headlines, other times perhaps due to a lack of understanding of what the VIX really is. In this article I am going to concentrate on a Tweet that I commented on last week.
Let’s look at the Tweet I am referring to and subsequent replies:
What is the VIX?
When analysing the VIX Index it is important to remember some basic facts:
- VIX Index is a Variance Swap so it’s value is not derived in the same way as say, equities or futures
- VIX Index is not tradeable
- VIX Index tells us the option market’s guess of volatility for the S&P500 on an annualised basis (it uses a range of At-the Money and Out-of-the-Money options). As the VIX uses 30 day options (roughly) we might want to turn that annualised figure into a monthly one (by dividing it by the √12)
So, for example a VIX value of 20 suggests that option traders believe the S&P500 Index will move in a +/- 20% range over the next year (with 68% confidence or one standard deviation).
To turn this into a monthly range expectation we divide 20 by √12 which gives us 20/3.46 = 5.78. So a VIX reading of 20 suggests a range for the S&P500 Index for the next month of +/- 5.78%.
Why % terms are often meaningless
Going back to the Tweet, the VIX was said to be having a “big day” because it was up 7.71%.
If the VIX was a typical, tradeable contract then a 7.7% move would indeed be something of note. But the VIX isn’t.
As stated by the Twitter account, the VIX had moved from 21.14 to 22.77. If we express this in terms of expectation for S&P50 volatility we would get:
- 21.14/√12 = 6.11 or a range for the Index of +/- 6.11% over the next month
- 22.77/√12 = 6.58 or a range for the Index of +/- 6.58% over the next month
- Change in volatility expectations = 6.58-6.11 = 0.47%
So this “big move” in the VIX Index actually represented less than half of one percent increase in the expected range for the S&P 500 Index over the next month. At a time when the Index was moving 1-2% or more in a day, a 0.5% increase in expectations over a month is clearly not a large move.
Is 20% a big move?
If this 7% move in the VIX isn’t large, would say, a 20% move in the VIX be considered big?
What if the VIX Index rose from 10 to 12? This would be a 20% jump but from such a low level it wouldn’t actually be too significant. A 20% increase would grab headlines but it doesn’t actually signify a big change in volatility expectations. Both 10 and 12 are low readings for the VIX Index.
When analysing VIX Index moves we should also consider the value itself and a range of other information before drawing any conclusions. Such information would include, the expected range the VIX is suggesting for the S&P 500 Index (over the next month) and whether VIX futures are moving in line with the VIX Index . The VIX Index and VIX futures are different types of products whose values are created differently and can therefore move in different directions to each other (another area of confusion on social media). We should also refer to the Implied Volatility of the actual underlying options.
The VIX may well be the most misunderstood contract in the financial world and in this article I am only focusing on one area where mistakes are made.
The 7% “big move” actually wasn’t a big move at all. Which is why I commented that it was meaningless to use the % change figure.
I find that a significant amount of VIX analysis on social media is flawed and I am sure it is a topic I will come back to.