Decoding the VIX Volatility Index and Market Climbs: A Comprehensive Analysis
Understanding the VIX and Market Climb: Is It Important?
Financial media often discusses the daily fluctuations of the VIX (implied volatility index) and what they suggest about investor sentiment. However, many investors may not fully understand what implied volatility measures. This article aims to clarify the concept of implied volatility and discuss other less-followed measures of implied volatility that can help assess whether implied VIX readings suggest bullish or bearish sentiment.
The timing of this discussion is crucial as the VIX has been rising alongside the market in an unusual manner. With the upcoming presidential election, changes in the Fed's monetary policy, and potential attacks on Iranian oil facilities by Israel, the increasing level of implied risk is not surprising. The question is whether the high VIX will continue to rise with the market, or if the market will correct itself.
Understanding the VIX
The VIX volatility index, also known as the “Fear Index,” is a widely followed measure of investor sentiment. Many investors believe that a rise in the VIX indicates growing concern about the stock market. However, this is not always the case.
The VIX uses the prices of various one-month calls and put options on the S&P 500, weighing them based on their time to expiration and the difference between the strike price and the current price of the S&P 500. Based on these prices, the expected variance of the S&P 500 is estimated. After some complex calculations, the VIX value is provided and expressed as an annualized percentage. Furthermore, the VIX is quoted as a one-standard deviation change. This means that there is a 68% probability that the S&P 500 will stay within the VIX percentage.
For instance, a VIX of 15 implies an expected annual volatility of 15%. In this case, the options market expects, with 68% certainty, that the S&P 500 will trade in a 15% range from the current level over the next year.
The graph below provides context for the recent range in the VIX. It shows how much change is and was expected for the S&P 500 based on the current (22), highest (37), and lowest (12) levels of VIX over the past year. The ranges vary significantly based on the VIX.
Put Call Skew
Put call skew measures the difference between put and call option prices at various strike prices for the same index or asset. Skew exists when the price of a put and call differs despite being equally distanced from the strike price and with identical expirations. Skew simply measures if investors are paying more for calls or puts.
A lower skew means investors are more aggressively buying call options than put buyers are looking for protection. Conversely, a positive skew implies investors seeking protection via puts are more aggressive than bullish call buyers.
The put-call skew helps us better understand whether bullish or bearish investors have a more significant impact on the VIX.
Put Call Ratio
Unlike the skew and VIX, the put-call ratio gauges sentiment by measuring the volume of options contracts. The ratio divides the volume of put options by the volume of call options over a specific period. A ratio below one suggests bullish sentiment, as more call options are being purchased than put options. Conversely, a ratio above one reflects a bearish sentiment.
CBOE Skew Index
Unlike the VIX, which measures expected market volatility with an expected one standard deviation or 68% band of accuracy, the Skew Index calculates the likelihood of extreme tail events defined as those of two to three standard deviations. While the Skew index and the VIX tend to move in the same direction, any differences can provide clues. Like the VIX, the Skew Index does not enlighten us on whether call or put trading drives the index.
Current Situation
This article was written to better explain the VIX and implied volatility. Additionally, it's important to consider whether the rising VIX alongside the market might be a warning worth heeding.
Such behavior is not typical, but it's not unprecedented either. The first graph shows that the uptick in the VIX is still very mild in the context of its 30-year history. The second graph pinpoints similar periods where the S&P 500 was within 1% of a record high. As it shows, it may ultimately signal a significant drawdown, but that signal may be too early. In fact, based on history, it could be years too early.
In addition to the VIX, we presented other implied volatility calculations. The two skew measures support the theory that the higher VIX is more of a function of put buying than call buying. However, the put-call ratio, which sits at a one year low, does not confirm the negative sentiment. In fact, it is quite bullish.
The message we take away from the mixed options data is that the market is anxious but not fully committed to an overly bullish or bearish stance. As we note at the beginning, plenty of potential events warrant unease.
Summary
If the VIX remains elevated or continues to increase and the other indicators confirm that put buying is driving the VIX higher, stay alerted for changes in market patterns. Pay closer attention to technical analysis, including where prices lay compared to their key moving averages.
The VIX is currently warning of the potential for bearish price action. While the warning is helpful, remember that if one were solely positioned according to the VIX between 1997 and 1999, they would have forfeited massive profits.
Bottom Line
The VIX and other volatility measures provide important insights into market sentiment, but they should not be the sole basis for investment decisions. It's crucial to keep in mind that these indicators can provide early warnings of potential market shifts, but they can also give false alarms. What's your take on this? Do you think the rising VIX is a warning sign that investors should heed? Share your thoughts and this article with your friends. Don't forget to sign up for the Daily Briefing, which is available every day at 6pm.
