The VIX: What Investors Need to Know

Traders Magazine Online News, March 5, 2018

Luke Oliver

There are approximately 500 stocks in the S&P 500 index. Easy. There are futures contracts based on the value of the S&P 500 index and there are options based on the value of these futures. OK. Next is the VIX, an index based on the implied volatilities of those options. This might need a little more explanation.

How the VIX Works

The implied volatility is a measure of how risky the market believes the S&P 500 will be in the future when pricing options. The more risky, the more expensive the option will be. Next, you’ve guessed it, there are futures contracts on the VIX and not just one, but several different dates into the future. The VIX and the original S&P 500 stocks should generally therefore move in opposite directions.

So, if the approximately 500 stocks in the S&P 500 began trading more erratically this should lead to more erratic futures and higher options prices, which should imply higher volatility/VIX. This is somewhat logical. But does it work in reverse? Yes. In a very simple example, which might sound familiar in the coming days, if everyone suddenly began buying VIX futures in a big way, we might expect VIX to rise due to that demand. If enough people are buying VIX futures, then someone has to be selling futures to them.

When a liquidity provider sells VIX futures they need to hedge their risk, so they will look back down the chain. If we agree that rising volatility correlates to falling S&P500, the liquidity provider might be forced to hedge the VIX they sold with a short S&P 500 position which is a bet that the broad market index will go down. This in turn can move the S&P 500 lower. The theory is then proven, that lower stocks and higher volatility often go hand in hand. Except in this example, it was the VIX and not the stocks that precipitated the move.

 

Bottom Line

I simplified that example, as best I could, however in reality all of these derivatives are interlinked and financial markets are continuously trading these derivatives against one another, keeping the relationships in line. They don’t do this to be kind. If any of the derivatives ceased to be in line with the others, an arbitrage (risk free) opportunity would be created and market participants seeking to capitalize on the difference would buy one instrument and sell another until they are back in line. That means that enough pressure on any one part of the chain will have an effect on the other parts.

For more information on related topics, visit the following channels:

• Equities