The subject of much debate and discussion in the media and wider trading community, the VIX is a misunderstood index. Referred to as the “fear index” in financial media, the VIX is simply a formula that indicates the implied volatility of the S&P 500 over a 30 day period. This is achieved by measuring the implied volatility of a slew of SPX (S&P 500 index) options.
As seen in the chart below, the VIX has an inverse relationship with the S&P 500.
Correlation between VIX and SPX, from Bloomberg/CBOE
What Does That Mean Though?
In a nutshell, the VIX goes up when more bearish options bets are being placed on SPX options. To further simplify that, when more SPX puts (options contract to take a bearish view) than calls (options contract to take a bullish view) are being bought, the VIX goes up.
When investors are afraid, they usually hedge their long equity positions with some puts on the broad market to protect their downside. These puts act a type of insurance against their equity portfolio. If the market takes a large dip, their equity portfolio will drop, but their put option will offset some of those losses.
VIX Overreactions
According Russell Rhoads’ book Trading VIX Derivatives, the VIX historically overreacts to dips in the S&P 500.
Here is a table from the book comparing the return of the S&P on it’s 10 worst trading days from 1990 to 2010 to the return of the VIX.
Additionally, here’s another table displaying comparison between VIX and S&P returns, each group being the worst days in the S&P’s history. As you can see, as the magnitude of S&P 500 drawdowns decrease, the frequency at which the VIX overreacts to those drawdowns decrease. This is presumably because with smaller drawdowns, comes less investor panic.
Manipulation Of The VIX
If you read any trading forums, you’ll inevitably see theories about large institutions manipulating the VIX index. It’s easy to write them off as conspiracy theories, but there is actually significant evidence of this happening.
Theoretically, the VIX index could be manipulated by moving the prices of the specific out-of-the-money SPX options used in the formula to quote the VIX. If done right before settlement of a futures contract, the contract will settle at the manipulated index price. Unlike wheat or S&P futures, VIX futures aren’t deliverable because the VIX is not an asset, but a formula. Due to this, VIX futures settle in cash based on the VIX index.
For example, XYZ Bank is net long 10,000 July VIX futures contracts. The contracts are currently trading at $10.00, and the VIX cash index is at $11.00. Right before settlement, they buy up all the illiquid SPX options that the VIX’s formula is based on. This makes the VIX cash index go up to to $12.00. Seconds later, settlement occurs and their July VIX contracts are settled at $12.
The above is a rudimentary example, the intention is to show you how and why it occurs.
A paper written by John M. Griffin and Amin Shams from the University of Texas as Austin found significant evidence of VIX manipulation. They found that significant activity occurred in the specific OTM options used to quote the VIX right at the time of settlement of VIX futures.
Here are some of their findings, all quoted from their paper.
- At the exact time of monthly VIX settlement, highly statistically and economically significant trading volume spikes occur in the underlying SPX options.
- The spike occurs only in the OTM SPX options that are included in the VIX settlement calculation and not in the excluded in-the-money (ITM) SPX options
- There is no spike in volume for the similar S&P 100 Index (OEX) or SPDR S&P 500 ETF (SPY) options that are unconnected to volatility index derivatives.
- If traders sought to manipulate the VIX settlement, they would want to move the prices by optimally spreading their trades across the SPX strikes and increasing the number of trades in the deep OTM put options consistent with the VIX formula. Trading volume at settlement follows this pattern, whereas normally deep OTM options are rarely traded.
- There are certain options that have discontinuously higher weight in the VIX formula but are otherwise very similar to other options. These options exhibit jumps in trading volume at settlement that are not present at normal times.
Using The VIX As An indicator
Here is a chart of the VIX with almost 30 years of market data. As you can see, it’s movement has some routine to it. During periods of sustained low VIX, the VIX continually drives lower until a random spike happens. After the spike, there is a “cooldown period” where volatility remains high for the time period, but trends downwards.
You will also notice that the VIX, for whatever reason, almost refuses to go below 9.
Based of the data given to us, we can assume that the VIX is a mean reverting instrument, it’s typical behavior is to trend downwards, have a large spike, then continue to trend downwards until it either,
- Hits 9, at which point it trends sideways until a spike happens
- A spike happens
These are simply tendencies that the VIX tends to follow, these have not been backtested, nor are they trade suggested.
Summary: The VIX Index
It’s clear that the VIX is an important index to gauge market sentiment, as well as for generating trade ideas.
In this article, we’ve learned:
- How the VIX is calculated
- How the VIX has a strong tendency to overreact to drawdowns in the S&P 500.
- How the VIX is likely manipulated
- How one can use the VIX as a trading indicator