Taking the Fear Out of the Fear Index

Often when there is a big down day in the U.S. stock market or, more specifically, in the S&P 500, the financial press cites the level of the Chicago Board Options Exchange's CBOE Volatility Index (VIX) as an indication of the level of fear in the marketplace. Now, although the VIX typically has an inverse relationship to the direction of the S&P 500, it is more than an index of fear. And it is definitely more than just something for the talking heads on TV to get excited about every once in a while.

The VIX is commonly called the investor's "fear gauge" because investors tend to be more fearful when market volatility is high and less so when volatility is low. While it may be a handy nickname, the "fear gauge" is really a bit of a misnomer and, when taken too literally, may lead to some confusion.

It is important to remember that the VIX measures the market's perceived future volatility (read: risk and uncertainty), most often associated with a fear that the market will drop. More specifically, the VIX measures the market's expectation of future volatility implied by S&P 500 stock index (SPX) options prices. While technically it does not measure the probability that the market is going to drop in the near future, at times it does represent a measure of fear that it will.

THE WILD CARD: VOLATILITY

Since the VIX measures implied volatility on SPX options, a quick refresher on volatility is probably in order. There are two general types of volatility: historical and implied. Historical volatility is measured by what a stock or market has done in the past; for example, the movement of the SPX over the past 20 days would be the foundation for the calculation of the 20-day historical volatility. Implied volatility—what the VIX measures—is a snapshot of SPX options, and it indicates what traders believe the future market volatility may hold. As volatility in the markets increases, particularly in the SPX, the demand for options increases, along with trading volume—and thus, implied volatility increases as well.

Volatility rises as a function of perceived risk in the marketplace. We all know that insurance costs rise based on the risk of loss associated with the insured person or asset. Homeowners' insurance in Florida the day before a hurricane hits landfall will always cost more than when there are no hurricanes in sight. In a similar way, volatility rises when there's a perceived higher risk in equities. Insurance can be expensive when you think you need it most. Sometimes this is true for options, as well.

A LITTLE HISTORY

The idea of creating an index to benchmark short-term market volatility stemmed from the work of Dr. Robert Whaley, Vanderbilt University, who wrote a paper on calculating volatility in 1993. His original methodology was to measure the market's expectation of 30-day volatility, which was implied by the pricing of at-the-money OEX options. At the time, S&P 100 options (OEX) were a more actively traded option series than SPX options, so the original VIX was based on the S&P 100.

In 2003, CBOE worked with Goldman Sachs to revise the VIX to focus on the S&P 500. More institutions started to choose SPX options for hedging purposes rather than the OEX, which resulted in volume and open interest on SPX options that outpaced the OEX options.

In 2004, CBOE introduced the all-electronic CBOE Futures Exchange (CFE) and began offering trades on VIX futures contracts. The idea of trading volatility in this way was pretty novel at the time, but it caught on.

Options on the VIX were introduced by CBOE in 2006, and have been one of the exchange's fastest-growing products. Just a year after their introduction, open interest on VIX options approached a million contracts.

VIX OPTIONS IN A NUTSHELL

Because of its substantial daily trading volume, VIX options have proven to be one of the best ways to gain exposure to the VIX index as an asset class. However, there are a few things to be aware of before placing a trade. Specifically, you should know about the unique pricing of VIX options (they're not directly related to the cash VIX), expiration dates (not on Fridays!), and how they are settled.

Pricing: With most indexes, the underlying index level is used to value the corresponding options. However, the proper underlying for pricing VIX options is the corresponding VIX futures contract. Why? To put it simply, there is no underlying basket of securities that can be purchased to replicate the VIX. The closest thing would be VIX futures. In comparison, a trader taking a position in SPX options could theoretically purchase a basket of stocks to replicate the S&P 500.

Both VIX options and futures are 100% anticipatory in their pricing. This means that sometimes VIX futures may trade at a premium to the VIX index, and other times the futures may trade at a discount. Basically, the level of VIX futures reflects where traders believe the VIX index will be at some expiration in the future. When futures are at a premium, this indicates traders believe the VIX index will go higher into expiration. When they're at a discount, the marketplace is anticipating a drop in the VIX. This is another reason the futures are the best underlying pricing instrument for VIX puts and calls.

Suppose the VIX December 25 call is priced at 2.50 and the VIX index is quoted at 28.15. There appears to be a mispricing of the December 25 calls—it seems the minimum intrinsic value should be 3.15 (28.15–25.00). But look again—if you use the VIX futures contracts that expire in December as the underlying instrument, the calls may appear more reasonably priced if the December VIX futures contract is anticipating a lower VIX than the current level.

Settlement & Expiration: VIX options, like other index options, are cash settled. Cash settlement upon exercise involves a cash transfer from the seller of an in-the-money option to the owner of that option. In the case of VIX options, this involves $100 for each point an option is in the money at expiration. For example, the holder of a 20 call would receive $500 at expiration from the holder of a short position in the 20 call if the settlement value for VIX options is 25 [($25–$20) * $100 = $500].

Remember that when holding VIX options through expiration, there are some intricacies involved in VIX a.m. (morning) settlement. VIX options officially expire on the Wednesday 30 days (or closest to 30 days) prior to the third Friday of the next calendar month. For instance, November VIX options expired on November 18, 2009, 30 days prior to the December option expiration of December 18. Although expiration is on a Wednesday, the options actually stop trading at the close of the Tuesday before settlement. The settlement level of the VIX is a special calculation based on the opening prices of all SPX options that contribute to the VIX calculation the following day.

What else do you need to know about the settlement price for VIX options?

The VIX level that results from the opening SPX option prices may vary substantially from the closing VIX index level the evening before. Part of this comes from normal overnight activity in the global equity markets. Also, since the VIX settlement level is determined with opening prices as opposed to the bid/ask used to calculate the real-time VIX, it may take some time for the actual settlement level of the VIX to be determined—as much as a few hours. As soon as the VIX settlement price has been determined, it is quoted by CBOE under the ticker VRO.

Here's a prime example of how the settlement price on a Wednesday morning can change from the closing VIX index level from the previous afternoon: the August settlement for VIX options and futures, which occurred August 19, 2009. The final trade for VIX futures on the Tuesday before a.m. settlement on Wednesday was 26.35, with the final VIX spot index print being 26.18. The following morning, due to overnight volatility, the August VIX settlement value for option positions was 28.76. That's 2.58 higher than the index close Tuesday evening.

To put this in context, a holder of an August 27.50 call likely would have expected his call to expire worthless based on the VIX index closing at 26.18 Tuesday afternoon. However, with August VIX settlement for futures and options priced at 28.76 on Wednesday morning, the holder of the 27.50 call, who went home Tuesday with a worthless option position, would now receive $126 in cash for his option. There's nothing like a worthless option suddenly popping up in the money! As with every trade, though, there is another side—the person who believed his short position in an August 27.50 call had expired worthless. The result of the settlement print for this trader was a $126 debit. For every good surprise, there is a bad one.

It's important to be aware of the intricacies of Wednesday morning settlement and the method used to calculate this level. If you have a profit in a VIX options position going into expiration, the wisest choice may be to simply close the position and take the profit. There may be some risk involved in holding VIX options until the settlement price is determined. Consider yourself warned!

BASIC BEAR STRATEGY:
BUYING CALLS ON VIX

Although it's not purely a fear index, an inverse relationship does exist between the S&P 500 and the VIX, especially in times of extreme negative moves in the S&P 500 (see fall 2008). As such, VIX options may be used when a trader has an opinion about the direction of the S&P 500, especially when she believes a big down move is coming soon. A trader bullish on stocks may consider a bearish strategy with VIX options, but more bang for the buck comes when the S&P 500 experiences a hard and fast fall. Let's look at an example of trading VIX options to benefit from a quick pullback in the S&P 500.

Suppose it's March 19, and you think that the S&P 500 is overbought at 1,150. Your guess is that a dramatic pullback is on the horizon. During the index's rise, the VIX has dropped from 30 to 21. In your opinion, stocks will fall in the next 60 days and the VIX should return to at least 30. As May expiration for VIX options is 60 days off, this works perfectly for your scenario. You also note that the May VIX futures are trading at 22.25—a slight premium to the underlying VIX index. Trading May VIX options, you would be using May VIX futures as the underlying for valuation purposes. Finally, the VIX May 25 call is trading at $2.10 (or $210 cash per contract, which is also your maximum risk).

Fast-forward 60 days—your market scenario turns out to be correct, and the S&P 500 drops more than 15% to 975. As predicted, the VIX climbs and VIX settlement for May comes in at 31.50. As a holder of the May 25 call, you receive a credit to your account of $650 [($31.50 – $25.00) * $100]. Subtracting the option cost of $210 nets you a profit of $440 (see Figure 2).

SUMMARY

The VIX has become the standard measure of market volatility by focusing on the future volatility implied by a variety of SPX options. The VIX reflects the overall market's opinion of how stock prices may move in the future. Dubbed the investor's "fear gauge," it is more accurate to think of VIX as a yardstick of investor uncertainty. Uncertainty may equal fear at times—but not always.

Although VIX has a general negative correlation with the S&P 500, and some traders use it in conjunction with other indicators to assess the market, VIX was not devised as a crystal ball to predict stock prices, the direction of the market, or market highs and lows. Instead, the VIX was created to predict the market's expectation of future fluctuations. As seen in late 2008 and early 2009, amid one of the most turbulent and uncertain periods since the Great Depression, for the most part, the VIX continues to accurately measure anticipated future volatility and to work just as intended.

Russell Rhoads, CFA, is an instructor for The Options Institute at the Chicago Board Options Exchange. Before joining the CBOE, his 17-year career involved positions at a variety of firms as a trader, quantitative and fundamental analyst, and financial programmer.

Schaeffer's Take

The CBOE Volatility Index (VIX) is often referred to as a "mean-reverting" index. Therefore, traders typically focus on historically important absolute levels to pinpoint potential pivot points. Through 2007 and most of 2008, the VIX chopped around aimlessly between 16 and 32, and didn't offer much in the way of clear insight. But what if the VIX is trending in a clear direction, as tends to occur around periods of market instability? In such environments, one can use simple moving averages to anticipate the VIX's next move, as former support/resistance levels no longer provide a good road map.

At Schaeffer's, we focus on longer-term moving averages that have shown historical significance, but are often ignored by technical analysts. In 2009, the VIX had an uncanny knack for respecting its 80-day and 160-day moving averages as it trended lower (see Figure 1). During the first quarter, the VIX was being supported by its 160-day moving average on pullbacks, but the trendline was finally breached in mid-March. In hindsight, this was a "tell" that volatility was entering a declining trend (an indication that the market was poised to rally), and it was confirmed by the fact that the 80-day moving average was turning sharply lower. Prior to the breach of the 160-day moving average, the VIX's mini-rallies in the first quarter had been capped at the 80-day moving average, a trendline that subsequently contained all VIX rallies into October 2009. Then, in late October 2009, the VIX broke decisively above the 80-day moving average—a potential warning sign that volatility was on the rebound. But the 160-day moving average lingered just overhead, capping the VIX's spike. And in the blink of an eye, the VIX again retreated sharply and a threat to the market's continued recovery was avoided.

While it is possible that the VIX could experience another mean-reverting period between 20 and 30, we would advise adding moving averages to your VIX analysis tool box, as they are helpful in deciphering trends and potential trend reversals.