Q & A. Why Does VIX Follow Market Direction?
Hi have a question about the VIX. Why is it that VIX increases and decreases more or less with the market rather than with the market’s volatility?
For example, yesterday the market was significantly down, and VIX shot up. Today, the market was significantly up. Not quite as much as it went down yesterday, but VIX almost returned to where it started? Why are option sellers less concerned about upwards volatility than downwards volatility?
Markets tend to fall much faster than they rise.That is not necessarily going to continue forever, but when it comes to trading options, perception is everything.
Thus, it’s not the market’s direction, in and of itself, that drives volatility, it’s the actions of the people who buy and sell those options.
With the banks once again making major negative headlines, there was a real fear that the end of the world was at hand.In those situations, option buyers dominate the activity.Portfolio protection is needed.Speculators want to buy puts. Investors panic.
Under those conditions, market makers who are selling those options raise the bids and offers for all options.When the buying stampede continues, prices rise again.This is a very fair and ethical behavior.If people are buying all you have to sell at one price and continue to bid for more, it’s foolish to maintain the price and get run over.Raising prices in the face of demand is well understood in the stock market, and everyone must understand that’s it’s just as reasonable when trading options.Supply and demand play a role in the pricing of options.When fear of a debacle is in the air, price is not a concern and those who feel they ‘must’ own options pay any price to get them.
When markets rise, those fears are alleviated.Whether this is reasonable or not, is not the issue.The point is that call buyers are more patient and don’t feel the need to panic.Few fear missing an immediate market surge and thus, there are many fewer people who ‘need’ to buy options right this moment – at any cost.
With options at ‘elevated’ levels and with few buyers, the sellers predominate.It’s not that they are anxious to force prices lower, but when there are more sellers than buyers, the market makers slowly but continuously drop the volatility number they use to calculate the value of the options they trade.With lower theoretical values for the options, the computers that generate the bid/ask prices produce lower bids and offers.Thus continues as long as therea re far more sellers than buyers.It also occurs when market makers are anxious to sell options – believing the panic is over.
But keep in mind that the blind selling of options is risky business and in today’s world, there are very few, if any, professional traders who want to accumulate big risk.Most hedge their option trades as quickly as possible.Nevertheless, when the markets rise, fear of a disaster goes away and option buyers are buying patiently, or not buying at all.
This doesn’t continue forever.At some point the sellers disappear and prices level.But it’s fear of getting clobbered – and the corresponding rush to buy puts – that drives implied volatility (and VIX measures that) of the options.And it’s not just puts – call prices must rise also (to prevent arbitrage opportunities.