by Vedran Vuk
Most regular market-watchers peek at the Dow Jones Industrial Average and the S&P 500 daily, but there’s another important index to follow regularly, the VIX (which is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index). Often in the news, the VIX is described as an index of volatility or an “index of fear,” but it’s really so much more than that. To call the VIX an index of volatility is only the most simplified description.
So, today, I’ll give you a slightly advanced explanation. This might not be the smoothest or most entertaining article in the history of Casey’s Daily Dispatch, but I hope you find it useful.
The VIX index is the direct result of the Black-Scholes options pricing model. Black and Scholes were two professors who made one of the most significant discoveries in finance ever. They found a clear mathematical way to calculate the price of put and call options. As a result, their discovery revolutionized the options market. So if anyone asks, “What do economics and finance academics do for us besides make armchair predictions?” – this is it.
We really have to give them a pat on the back. Their pricing model isn’t the easiest equation. Don’t even try to solve this thing, but for those that simply want a look at the monstrosity tormenting finance students across the globe, here it is:
The price of a call option = S0N(d1) – Ke-rtN(d2)
The price of a put option= Ke-rtN(-d2) – S0N(-d1)
d1= (ln(S0/K) +(r+σ2/2)T)/ σ√T
d2= d1 – σ√T
Glad you didn’t major in finance now? Actually, despite the formula’s complex appearance, all the numbers necessary to calculate it are publicly available – such as the time to maturity, strike price, interest rate, spot price, etc. However, one variable will always be missing: implied volatility (σ). And hence you must solve for it. But guess what? You don’t have to be a math whiz to do it; thankfully the VIX index does it for you.
The VIX shows the implied volatility in 30-day S&P 500 options as computed by this equation. With just a click of the mouse to the VIX, you can see the result without all the math.
But you may be thinking, “Wait, but that’s just volatility, why the long explanation?” Not quite. Yes, I could find the historical volatility with some basic statistics and historical S&P price data. However, this is backward-looking volatility and yesterday’s news.
So, why not just check the present state of the market? Sure, checking the price of the Dow and S&P is always useful. But the VIX does something more amazing. It does not derive past volatility or current volatility, but instead it’s a predictor of future volatility.
Since call and put option prices have built-in expectations of the future, finding volatility through them reveals those expectations. Every other index shows you the past – what happened a year ago, a month ago, five minutes ago. Only the VIX shows you what the market thinks will happen to volatility next. Naturally, this makes it far more useful than historical data.
So, as you can see, the VIX is much more valuable than the financial news ever explains. It’s not just a measure of volatility or fear. It is a moving prediction of the future. That’s why stock analysts get very afraid of a rising VIX. It’s a warning signal of things to come. For example, in the chart below, notice the giant spike in the VIX around the Greek crisis. Though the actual market didn’t move that wildly, the VIX certainly did, giving an early warning sign of a possible catastrophe.
A Note on Today’s VIX
Lately, the VIX has been in a downward trend, but that could change suddenly. Look at the pattern across the year. The market panics about future volatility, and then slowly everyone starts to calm down. And then as soon as they’re too calm, the VIX jumps up again. This pattern has repeated itself three times within a year.
Looking at the chart, the VIX again looks too calm. Could that mean another spike just around the corner? Maybe…