The CBOE Volatility Index, or VIX, is a real-time market index measuring the stock markets expectation of 30-day forward looking volatility. Often referred to as the “fear gauge”, The VIX is an instrument used to measure volatility, or risk. While there are a couple of ways to measure volatility, the VIX uses implied volatility. Where implied volatility differs from the others is that implied volatility infers the value base on option prices, whether they are being bought or written. But, before anyone should look to the VIX as some kind of future volatility forecast, they must first ask themselves “is the VIX really telling me something I don’t already know?”
It seems as if the VIX reveals very little that is not already reflected in the current and past S&P 500 performance. The VIX and S&P 500 tend to be inversely related, meaning when one goes up the other goes down. If the VIX is looked at as a leading indicator for the next 30-days, it should show a major price change before a large change in the S&P 500. This hardly is the case. In February of 2008, the VIX saw a significant spike in price, but this was after the S&P 500 dropped 16% the month prior. The VIX spiked again in October of 2008, a few weeks after the S&P dropped to its lowest point in over a decade. David J. Hait of OptionMetrics conducted a regression test on the VIX versus the S&P 500. Hait found that 98.8% of the daily variation in the VIX can be explained by current S&P 500 returns and lagged VIX values. Furthermore, this means that no more than 1.2% of the VIX’s daily variance can be explained by changes in market sentiment which are not already reflected in the S&P 500 index. Given that a staggering percent of the VIX’s daily variation is explained by existing measures in the S&P 500, its power as an indicator is acutely inflated.
There are obvious flaws in the VIX. This does not mean it cannot be used to the investor’s advantage. Different VIX traded instruments, such as VIX Exchange-traded notes (ETNs), can be used to effectively hedge risk in a portfolio. Another way to invest in the VIX is to buy VIX futures and options. Futures and Options can yield higher potential returns, but carry more risk.
Though the VIX does little to reveal a future volatility forecast, investors can still use it for different investment opportunities. To read in more detail about the VIX, click on the reference links below.Subscribe to the Dunham Blog