What the volatility index is telling us
Chris McKhann | [email protected]
The VIX is known in the popular media as the "fear gauge," but its real name is the CBOE Volatility Index, and that is what it really is: just a statistic that is derived from the SPX options in the front two months. It gives us an idea of the volatility that traders are expecting in the next 30 days.
The VIX closed Friday at 12. It has since jumped above 17, on Monday and again yesterday. A 40 percent move higher is definitely significant, but the VIX is most closely tied to the actual volatility in the SPX, which has seen a bigger increase. A month ago the 10-day historical volatility of the SPX (measuring the day-to-day past movement) was 5 percent, but today it climbed more than 19 percent for a gain of almost 300 percent.
There are a few ways of trying to take advantage of increasing volatility. We hear people recommend "buying the VIX," though the index is just a statistic, not a tradable entity. You can buy VIX futures, but those have different prices. And the VIX options and exchange-traded funds and notes are all based on those VIX futures.
Usually the VIX futures trade at an increasing premium to the spot VIX, a situation known as contango. But at times of market turmoil, the spot VIX can climb above the futures, which is what we have right now.
While the VIX futures, calls, and exchange-traded funds are usually quite expensive hedges on long equity positions, it is times like these that they become quite appealing. Yes, the data means that traders expect the spot VIX to calm down to the level of the May futures in the next month, but research has shown that the volatility index typically does a better job than the VIX futures in predicting where volatility will be going forward.
Volatility comes in waves, and it has been building in the actual volatility of the SPX of the last month and in the VIX in the last three days. I can't say when this wave will recede, but I do know that it makes sense to be prepared for more.
Using the VIX products usually has a negative expectation, but when the volatility index is above the futures, it becomes a very appealing trade.
(A version of this article appeared in optionMONSTER's Advantage Point newsletter of April 17.)