081610 - The VIX - This is not your Mother’s Vicks

The VIX - This is not your Mother’s Vicks

“VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. It is not backed by anything and positions held are merely a prediction of a future. A high value corresponds to a more volatile market and therefore more costly options, which can be used to defray risk from this volatility by selling options. Often referred to as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period. The VIX Index was introduced in 1993 in a paper by Professor Robert E. Whaley of Vanderbilt University[1].” – wikipedia: http://en.wikipedia.org/wiki/VIX

Now that I’ve cleared that up, I’ll give you my version. VIX or volatility is a market indicator. Just as the S&P 500, NASD 100, etc. VIX is a general market indicator for options pricing. Like the market indices, the VIX can go up or down. Unfortunately, the volatility for options on a stock you are looking at may not even move with the VIX or worse it could move in the opposite direction to the VIX! It happens and the mystery is not so great. As the head of a trading room once told me, “prices go up because of an imbalance of buyers to seller and they go down due to an imbalance of sellers to buyers.” Shakespeare could not have said it better. Also, keep in mind that stocks and sectors get spooked and prices can change in these areas first leading or lagging the overall market.

Let’s forget the above and remember that the VIX is a good indicator to look at, even if it is the only indicator. The rule here is sell volatility over 28/buy volatility under 12. The problem is getting a volatility quote on and individual stock. If you really want to have fun, ask one of the boiler room guys who call you about options. They will wax and wane about their skills. When the opportunity arises, ask them, “What is the quoted volatility for GM?” Hint: GM at this writing does not have options. Anyway, it is nearly impossible to get a volatility quote on any individual stock option from a retail desk.

Back in 1973 two really smart guys named Fisher Black and Myron Scholes wrote a paper that became the basis for options pricing models. Volatility became one of the major components of their model and every options pricing model since then. Therefore, VIX is important and it gives you a very simplistic and generic idea of where volatility is priced. These models can be very simple and very complicated. Who has the better model? Who cares! We are not in this for getting the absolute best price for any single option. Option’s pricing involves the use of many dynamic variables like the spot price of the underlying stock, forward interest rates, etc. Things that individually can create real stress in trying to price correctly and in aggregate can drive you nuts or to write your own pricing model.

Overall, as an indicator, I find that a high VIX provides an indication that overlooked stocks may be attractive and a low VIX means nothing much looks good. Why is the VIX important? It is just another piece of information that an informed investor should be familiar with. Also, dropping the old VIX bomb in cocktail conversation is fun and who doesn’t want to be the life of the party?