New Calculation of VIX
First of all, the VIX will now be calculated on the SP500 (SPX) instead of the SP100 (OEX). This is a better representation of the overall market: the OEX is the top 100 companies of the SPX weighted by capitalization.
Secondly, the VIX will now be calculated based on something called "local volatility". Previously the VIX was calculated by taking the nearest to the strike options (of various expirations), whatever they happen to be on any given day, and weighting the implied volatilities of those options to come up with one number. For example, if one day the OEX closes at 519, the next day the VIX would be calculated on the 520 strike options of various expirations. If the OEX then closes at 504, the following day they would use the 505 strike options. The new methodology instead will take a multitude of strikes (say ranging from 480 to 530) and expirations (a basket of options if you will) and then apply a weighting.
The new methodology will better represent overall implied volatility in the following respect. Out of the money puts normally trade at a higher implied volatility than at the money puts (this is called the "skew"). This skew is not reflected in the old methodology, which floats the calculation to the always nearest at the money strike, but will be in the new methodology. For example, if one day out of the money puts are seriously bid up in price (out of the money puts change in implied volatility terms much more readily than at the money options), but the at the money puts stay the same in price (the skew widens), the VIX using the new methodology would show an increase where the VIX under the old would not.
This new methodology is a better indicator of sentiment. I have indicated in the past that I had paid little attention to VIX because of its mathematical shortcomings and instead focused on the skew. Now I will pay a little more attention.
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