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Minyan Mailbag - A Question About the VIX



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Professor Succo,

One thing has puzzled me about the vix, vnx, vxo. Since these help determine option prices, why doesn't a strong move in EITHER direction cause them to go up. Every time the markets rally, even when it is a scorcher, VXN, VIX, VXO seem to drop.

IMO that should cause those prices to rise not drop. Long flat periods of channeling or slow very steady moves in either direction should move the VIX lower (to my way of thinking). Prices of puts cannot go up without prices of calls moving up or put/call parity gets destroyed does it not? So if one rises the other has to rise as well.

Well if a STRONG move up is underway, why the heck should option prices be falling (the volatility component anyway) across the board.

Again to me, what makes sense is a slow steady move, or a rangebound market should move the VIX lower, not that huge rally like we saw today.

Minyan Mike Shedlock

Minyan Mike,

The VIX and other volatility indexes are directly based on actual option prices: they are an estimate of the actual implied volatilities of the index options themselves. So to look at what is driving these indexes, we need to look at what is driving actual option prices.

Option prices are determined exclusively by supply and demand. When a market rallies, and usually when it rallies significantly, two things happen:

First, the demand for options in general decreases as hedgers are less likely to buy puts. This may seem counterintuitive, but that assumes that hedgers are rational. A rational response by a hedger might be to buy protection in a rising market in order to hedge higher prices at a cheaper cost. But hedgers (humans) don't really act that way. When markets rise they become more sanguine and feel less of a need to hedge. Hedgers actually increase their demand for protection when prices are falling as fear increases.

The second thing that happens is that the supply of options increases as over-writers sell calls into a rising market. This is a more rational response.

So even if stock prices rise quickly and actual volatility increases, the implied volatilities of options, which affect the volatility indexes, declines because the demand for options decreases and the supply increases.

Hope that helps.

Prof. Succo

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