The CBOE Volatility Index®, or “theVIX®”, has been at historically high levels for a while now. The question for today is: How long can it stay this high? To answer, let’s first examine what the VIX is and why it rises or falls.
Basically, the VIX is a measurement of the implied volatility on the S&P 500. More specifically, the VIX measures the implied volatility of hypothetical 30-day options listed on the SPX, which is the index contract that represents the S&P 500®.
Implied volatility, as many of us know, is the volatility component embedded in option prices. When option-market participants buy up options—usually in expectation of future volatility—implied volatility (and therefore the price of the option) rises. Likewise, when market players sell options—usually in expectation of waning volatility—implied volatility (the price of options) falls.
A comparison of the “market volatility” of fluctuations in the S&P 500 index and the embedded “option volatility” or the VIX can be easily done mathematically. These figures are both stated in terms of annualized standard deviation of daily price changes. The actual standard deviation of the S&P index is calculated by past price fluctuations, while the implied volatility represents expected price volatility.
For example, if the annualized standard deviation of the value of the S&P 500 is, say, 43 and the VIX is 43, that means over the next 30 days the volatility of the SPX is expected to remain constant. If the VIX is higher than the calculated standard deviation of the S&P, the market expects volatility to be higher in the future. If the VIX is lower, expectations are for lower actual volatility in the S&P.
For the VIX to remain at this lofty level, the S&P 500 needs to remain volatile. Otherwise, the options will be mispriced creating an arbitrage scenario. The moral to the story: when the market stops moving as much as it has been, the VIX will fall.
Dan Passarelli
Market Taker Mentoring LLC
