VOLATILITY INDEX (VIX)

In September 2003 the CBOE changed the way the VIX is calculated. The new VIX is derived from the prices of all near-term at-the-money SPX (S&P500) puts and calls and out-of-the-money puts and calls. Deep-in-the-money options are excluded. This methodology is also used to calculate the NDX (Nasdaq 100) volatility index (symbol= VXN).

(Click here to see a live example of the VIX)

The old VIX is still available but it now has the symbol VXO. It still uses the old calculation method, which uses the Black-Scholes pricing model. The VXO is calculated by taking the weighted average of the implied volatility of 8 OEX (S&P100) calls and puts with an average time to expiration of 30 days. In other words , It forms a composite hypothetical option that is at-the-money and has 30 days to expiration. (An at-the-money option means that the strike price and the security price are the same.) VIX represents the implied volatility for this hypothetical at-the-money OEX option.

OEX options are by far the most traded and most liquid index options on the CBOE. Because of their dominant activity, OEX options represent a good proxy for implied volatility of the market as a whole. As OEX trades, VIX is updated throughout the day, and can be tracked as an intraday, daily, weekly or monthly indicator of implied volatility and market expectations.

(Click here to see a live example of the VXO)

The CBOE NASDAQ Volatility Index (VXN) employs the same formula used to calculate VIX, which is based on the implied volatility of S&P 500 index options. This formula is derived from a basket of put and call options. Some are out of the money, some in the money, and some at the money. The resulting VXN represents the implied volatility of a hypothetical 30-day option that is at the money.

(Click here to see a live example of the VXN)

Typically, VIX (and by extension implied volatility) has an inverse relationship to the market which means that high readings are oversold (excess of bearishness) and low readings are overbought (excess of bullishness).

The value of VIX increases when the market declines and decreases when the market rises. It seems that volatility would be a two-way street. The stock market, on the other hand, has a bullish bias. A rising stock market is viewed as less risky, and a declining stock market more risky. The higher the perceived risk is in stocks, the higher the implied volatility and the more expensive the associated options, especially puts. Hence, implied volatility is not about the size of the price swings, but rather the implied risk associated with the stock market. When the market declines, the demand for puts usually increases. Increased demand means higher put prices and higher implied volatilities.

The VIX (and VXO and VXN) measures fear and optimism as manifested in options activity. When large numbers of traders become fearful, the VIX reading rises, and when complacency about the market reigns, the VIX reading falls. And since the vast majority of put/call buyers are wrong and lose money, it's usually a smart move to fade (go counter to) what the VIX says the crowd is doing.

Anyway, raw VIX numbers are of limited value. The VIX indicator is most useful when used in combination with some technical indicators : MACD, RSI, Stochastic, Bollinger Bands linear regression channel or percent bands . Positive or negative divergences visible on those indicators can be used to make predictions of the future trend.

Comparing VIX action with that of the market can yield good clues on future direction or duration of a move. The further VIX increases in value, the more panic there is in the market. The further VIX decreases in value, the more complacency there is in the market. As a measure of complacency and panic, VIX is often used as a contrarian indicator. Prolonged and/or extremely low VIX readings indicate a high degree of complacency, and are generally regarded at bearish. Some contrarians view readings below 20 as excessively bearish. Conversely, prolonged and/or extremely high VIX readings indicate a high degree or anxiety – or even panic – among options traders, and are regarded at bullish. High VIX readings usually occur after an extended or sharp decline and sentiment is still quite bearish. Some contrarians view readings above 30 as bullish.

Conflicting signals between VIX and the market can also yield sentiment clues for the short term. Overly bullish sentiment or complacency is regarded as bearish by contrarians. On the other hand, overly bearish sentiment or panic is regarded as bullish. If the market declines sharply and VIX remains unchanged or decreases in value (towards complacency), it could indicate that the decline has further to go. Contrarians might take the view that there is still not enough bearishness or panic in the market to warrant a bottom. If the market advances sharply and VIX increases in value (towards panic), it could indicate that the advance has further to go. Contrarians might take the view that there is not enough bullishness or complacency to warrant a top.