Volatility Index (VIX)

October 26, 2011 By Alireza Panahi, PhD http://www.geobuild.ca Back to Geobuild website VIX (Volatility Index) was introduced in 1993 in a paper by Professor Robert Whaley at Vanderbilt University and later adopted by the Chicago Board Options Exchange as a benchmark of short-term market volatility over the next 30 day period. The direction of volatility can not be realized using VIX as it represents an expected annualized change over the next 30 days in either direction. The VIX is the square root of the par variance swap rate for a 30 day term initiated today. Pressent day VIX at 25% for example, means an expected change of 25%, up or down, over the next 30 days, normalized to 12 months: 25%/12 = %7. In this sense, it is important to note that VIX is forward-looking volatility that investors expect to see, not backward-looking volatility that has recently been osbserved. VIX enables investors to compare the merits of different financial instruments. Professor Whaley (2008 )compares VIX to bond's Yield to Maturity, an estimation of futute return. Just like a bond's yield is implied by its current price, VIX is also implied by the current prices of S&P 500 index options and represents expected market volatility over the next 30 calendar days. Whaley (2008) provided a probabilistic interpretation of VIX levels using char below (Figure 1). A VIX level of 60, for example, presents a 50-50 chance the rate of return for the S&P 500 index will be up or down by less than or more than 11.5 percent over the next 30 days.

Figure 1. VIX as the " Investor Fear Gauge" VIX is an indicator that reflects investors' level of fear and confidence in the market. Since the inception of VIX as an indicator, market analysts have been trying to find a precise meaning to an index level. From a technical analysis point of view, it is interesting to apply traditional

techniques to its chart. Figure 2 shows levels of VIX as of October 27, 2011, with VIX standing at 25.37%. Intersting to note that the RSI and stochastic levels are both marking below 50%. But to understand the behaviour of VIX as a function of market activity, we should look to its history.

Figure 2.

Figure 3. Figure 3 shows daily chart of S&P500 through May 2010 to October 27, 2011. Subchart # 1 plots, for the same period, daily measures of VIX. Subchart # 2 is the Money flow Index, which is simply typical price (high + low + close/3) divided by volume and is a measure of quantity of stocks traded eveyday. Subchart # 3 is the 120-day moving correlation coefficient values for S&P 500 and VIX. Several observations are noteworthy. S& P 500 reached its peak from July 2010 low in May 2011 and broke its long-term uptrend in late July 2011. For the same same period ( July 2010- july 2011), VIX trended in the opposite direction when VIX reached its bottom the exact same time that S&P 500 reached its top. The bottoms in the S&P 500 in August and late September 2011 are also marked by peaks in VIX at exact same time. Also note the divergence between MFI indicator and S&P 500 when S&P 500 made a lower low but MFI failed to reach its previous bottom. A look into historical numbers of S&P 500 and VIX reveals intersting facts about the relationship between VIX and the stock market. Figure 4 shows a plot of daily S&P 500 closing values since January 3, 1990 as a fucntion of VIX (for the same period). Data are available for download from a vareity of sources including http://finance.yahoo.com.

Figure 4.

Table 1 shows the summary statistics for closing numbers of VIX and SP500 over sample period (19902011): VIX S&P 500
Min: 9.31 Mean: 20.50 Median: 19.02 Max: 80.86 Total number of points: 5498 Std Dev.: 8.26 Min: 295.46 Mean: 943.05 Median: 1056.58 Max: 1565.15 Total number of points: 5498 Std Dev.: 370.62

Figure 4 may reveal some important characteristics about the behaviour of VIX as a function of market movement. It is obvious from the chart that VIX and S&P 500 generally move in opposite directions. As stock prices increases, investors become less nervous and more confident, and as a result, VIX subsides. In some occasions, although not so common, a run-up in stock prices caused a run-up in volatility. Investors can become nervous during uptrends. It is interesting to note that just like an insurance policy, investors routinely buy index puts as a hedge factor when they are concern about potential drops in the market, causing the market to trend higher. Note that the distribution (number of points) patterns with which VIX remained at or above a certain standard deviation (STD) levels provide a sense of market anxiety. The majority of points are clustered between 1 STD which statistically covers 68.2 % of the

entire data points (normal behaviour). There are incidents where markets trade at statistically less significant VIX levels, for example at 2 xSTD or 3 xSTD. These are characterized as VIX abnormal behaviour.

Figure 5. Figure 5 shows the VIX change of attitude as a function of market participation (measured by Money Flow index). Market participation is simply calculated as price times quantity of shares traded (in either direction, short or long) for the sample period. Trend A-B relates to times when market nervousness (measured by VIX) subside s as market participation improves until VIX reaches a support zone around 10-20% when participants become overconfident and euphoria kicks in, causing VIX to move in opposite direction. Two separate populations in Figure 5 may represent uptrend and downtrend movements, but further study is needed to investigate such observation. Summary: Present values of VIX should be used as a measure of implied volatility in the stock market over the next 30 days. VIX level at the present time only points to level of future volatility in either directions, so investors could measure probable rate of return in their stock portfolios. As a measure of market anxiety, VIX subsides as market rises, but it also reacts to market participation. VIX levels off when it reaches a support level of over- confidence at 10-15% and resistance at about 40% (fear). _______________

Reference: Whaley, Robert E., 2008. Understanding VIX. Electronic copy available at http://ssrn.com/abstract=1296743