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What Really Drives the VIX

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I have described in more detail in a past piece how the VIX index is calculated, but suffice it to say that it basically averages the prices hedgers and speculators are paying for index options.

For example, a VIX of 14.5% means that based on index option pricing, the market expects the stock market to move up or down 14.5% over the next year. A higher VIX means market participants expect the market to be more volatile. The VIX index is used by many as a contra-indicator to gauge market sentiment, the logic being the higher the VIX, the more worried traders are.

Since a higher VIX indicates traders are paying higher prices for index options, most would infer that traders are also paying higher prices for individual stock options. This is not always the case, as we are currently seeing: traders are not selling individual stock options cheaper as the VIX has recently declined.

So if individual stock options are not indicating complacency (at least not to the degree that they were when the VIX was last at these levels), how can the VIX be? How can the VIX be dropping while the option prices that comprise index option prices are not?

The answer is that there is another variable that drives the level of index option prices besides an increase in component (the underlying stocks that comprise the index) volatility. Index option prices depend heavily on the correlation between the underlying component stocks that comprise the index.

Suppose that an index is made up of only two stocks XX and YY. Further suppose that the actual volatility of these two stocks and their option prices remain very stable over time. The price of the options of index XXYY can increase even though the option prices of the stocks do not if the correlation between XX and YY increases.

If XX goes down by one point and YY goes up by one point (negative correlation) in the same day, the index XXYY will be unchanged and the option price of the index will reflect low volatility. But if XX and YY both go up one point (positive correlation) in the same day, the index XXYY will move quite a bit and the index option price will reflect higher volatility.

In most cases, a declining VIX will reflect lower volatility in component stocks. But there are situations, like now, when stocks are not showing a high degree of complacency but the VIX is, simply because the correlation between the underlying stocks has declined.

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No positions in stocks mentioned.

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