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Are the Volatility Indices Valid?


The VIX has its moments.

A reader writes:

I have had troubles with the philosophy behind the family of "volatility" indices for quite some time, and I think I'm finally able to rationalize my concerns. It may be that this is an old argument, but the fact that the indices still exist, suggests to me that misinterpretation is always in the shadows.

These indices are a far cry from my definition of volatility. At best, I see these as "pessimism" indices, perhaps a semblance of downside volatility.

Volatility is a dual-edged blade. It slices in both directions. So volatility should be higher when there are large swings in either direction. Volatility should be lower when there are smaller swings in either direction.

Consequently, I struggle to understand how the volatility indices are a valid tool whose purpose is already served by the S&P 500.

Very much yes; I totally agree with the angle here. VIX in the very here and now, meaning this May, has added some value in that it's moved way beyond the bounds of what we've seen in the market so far. Take away the flash crash and we're off 8% or so from the highs in the SPX. That's a relatively tame correction given the persistent rally from last March into this April. The VIX however has rallied something like 220% in less than a month. And it's important to remember that at the time, a mid 15 VIX wasn't as dirt cheap as pundits had us believe. Realized volatility in SPX was about 7.

So what was the value add? Well, VIX certainly presaged this wave of fear. But that's more the exception than the rule. Most of the time the VIX does as the emailer says. You can glean the same info just watching the SPX. The VIX going up X% doesn't cause SPX to then go down Y%, rather it's a reflection of SPX going down Y%.

Again though, not in May 2010. The VIX is percolating and the market's not really crashing. There are two conflicting interpretations. One is that the VIX is predicting a crash, the other is that the fear needle has moved way too far too fast. Take your pick, but we won't know for sure until it hits the rearview.

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