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Minyan Mailbag: VIX volatility



Editor's Note: Minyanville is a community of people who share an interest in fiscal literacy. As perspective is an important aspect of our daily routine, we share this email with hopes that it adds balance to your process.

Professor Succo,

We have the VIX at multi-year lows and yet I've seen at least one study that shows a large (growing?) number of stocks are moving 1% or more in a day. In other words, aggregate volatility measures are not agreeing with more micro measures.

Does this ring a bell?

Minyan EM


This is basically true.

There are two drivers of the VIX (a surrogate of index option volatility): average volatility of the individual stocks and the correlation of those stocks.

We can all understand the implications of lower average volatility of stocks on the VIX.

The second is less clear but just as important. As the correlation between stocks drops, the VIX will drop as well even if the average volatility of those stocks does not go down.

Let's look at an example to make that clear. Pretend the index consists of only two stocks, A and B. The average volatility of A and B does not change for our example.

If A is up and B is up the same day, the index will be up and therefore show some volatility. A and B are correlated. But if A is up and B is down, the index will show no change and no volatility. A and B in this case are not correlated.

So the less correlated the stocks of the underlying index, the less volatile the index.

I mentioned a few days ago that even though the VIX was dropping rapidly, our fund was not losing money. This is because we are not long index options, but long options (volatility) on individual stocks.

The VIX has been dropping while individual stocks are showing some volatility, but the correlation between those stocks has been dropping.

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