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VIX: Still the Fear Index?

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Or does it now measure real volatility?

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The CBOE Volatility Index, VIX, was created and began tracking market data in June, 1988. For most of its 20-year history, VIX was considered by many traders and investors to be a measure of the current fear or complacency of market participants. VIX is an up-to-the-minute index. According to the CBOE, "VIX is calculated directly from the price quotations of nearby and second nearby S&P 500 Index options spanning a wide range of strike prices. The VIX calculation is independent of any theoretical pricing model." VIX tends to increase as markets fall, and decrease when markets rise. There's a very good reason why this is true (more on this below).

As every trader remembers, 2008 was a very volatile year for stock markets around the world; the levels of implied volatility -- as measured by VIX -- increased dramatically as the market tumbled. A record closing high (81) was established during the worst of the market slide.

Why VIX Rises as Markets Fall

Markets decline much more rapidly than they rise. One popular phrase that describes this situation is that "markets are much more likely to melt down than they are to melt up." Thus, when markets begin to decline, market participants buy options. Some buy as speculators, hoping the downward move will continue. Others buy options to protect the value of their investments. The more the market falls, the more option buyers appear in the marketplace, searching for insurance. They need to buy options urgently.

As you're aware, as more buyers appear (and sellers disappear), there's upward pressure on option prices. That shouldn't be surprising, as stock prices also fall rapidly as sellers predominate and buyers back off. Add to that the urgency displayed by some put buyers and it's no wonder that option prices can surge.

Why are all options affected, and not only puts? It's clear that most option buyers want puts under these circumstances. But don't forget that a trader can buy calls and sell stock to create a synthetic put. Efficient markets don't allow those synthetic puts to trade at a bargain price.

There's an arbitrage strategy (reverse conversion) that would provide free money to those who bought synthetic puts at a cheap price and sold "real" puts at a high price. When the market is working, as it is virtually all the time, free money is not available. Thus, as put prices move higher due to increased demand, an increase in implied volatility, and a falling stock market, call prices fall more slowly than you might expect from the option's delta.

In extreme cases, calls increase in price (an amazing occurrence to unsophisticated option traders) when the implied volatility moves high enough. (That's exactly what happened during the crash of October 1987. All options increased in value as VIX surged to an incredible 150. That value was calculated after the fact because VIX hadn't yet been created. People were scrambling to buy any option they could get -- at any price -- to enable them to hedge, or reduce the risk of owning investments.)
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No positions in stocks mentioned.

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