VIX TWAIN AND MAGIC MIRRORS
For many years, market pundits have proclaimed the demise of the usefulness of the VIX Index. This article will present the proper way to interpret the VIX Index which refutes the nebulous claims of its detractors.
As far back as 2016, there has existed the view that the "VIX is dead". VIX ETFs have "killed" VIX twice. Once in 2016 and once in 2018. The dollar took the fallen VIX’s place as the "fear indicator" in 2016 as well. It was later decided VIX wasn’t actually dead but would be. Much to our relief, the VIX was recently proclaimed alive again. I say all of this in tongue and cheek. Seeking to know if markets have structurally changed is both necessary and difficult to know. Comments from informed participants are always welcome. But much of these proclamations all seem to make the claim that VIX no longer foretells something they thought it should foretell. Often, that "something" is not what the VIX was created to predict.
But like Mark Twain, this VIX Twain may not agree with these market coroners and quip, "[t]he reports of my death are greatly exaggerated."
If what many pundits suggest what the VIX is were correct, then they would be right. The VIX would dead. However, it would be more correct to say the VIX was never created to be what they had imagined it was–an instrument with "explanatory power for leverage", and other such proclamations. Many hold the naïve view it should spike wildly on any hint of future risk. The VIX is not the market’s magic bullet or magic mirror. It’s just a regular, ordinary mirror.
Magic mirrors appear through literature and mythology. Special powers include the ability to see the past, present, and future (Vulcan’s Mirror).
They have included the ability to show something other than reality (Venus’ Mirror), to reveal desires and motives (Mirror of Cambuscan), or to reveal a reverse reality (Looking Glass). In most of the allegories involving magical mirrors, like Vulcan and Venus, they end in tragedy. When mirrors are used as they were created to operate, like Perseus and Medusa, they are tools for triumph. The moral of the story is through the power of reality and truth, not illusion and deception, do we have the power to overcome.
Therefore, to succeed in using the VIX properly, we must operate under a correct understanding of what the VIX is and what it is not. If we look to the VIX as a magical power to protect against all market volatility–we will be disappointed. If we expect it to foretell market pitfalls and reveal market cobwebs–we will be deceived. If we use it to reflect a simple reality, we will have much greater success.
Why would anyone pay more for an option than what is justified by the market’s current volatility profile? They might do so if they thought volatility will rise, but not too much more than what the existing baseline of volatility exerts. The opposite for those who sell options is also true. For this reason, a difference, but not a hugely significant difference, exists between implied- and realized
–volatility. For this reason, implied volatility will effectively track what realized volatility demands. Plain and simple.
Another use for the VIX is to express market direction. Because volatility can increase or decrease at an asymmetric (i.e. potentially magnified) relationship to price moves in the S&P 500, some market participants prefer to use the VIX (via futures and options on VIX) to express a directional view of markets. A more lucrative trade may be made by going long VIX vs. shorting the S&P 500 in a down event. The converse can be true for capitalizing in market up moves. VIX is therefore also the reflection of supply and demand of market speculators as it pertains to the collective view of market direction.
The above two statements regarding VIX mean two things. One, levels in the VIX reflect the realized volatility of the S&P 500. Two, the VIX also reflects the day–to–day inverse movements of market direction as reinforced by market participants. Therefore, the VIX will express the overall volatility scenario of the market plus or minus any supply and demand occurring within that context.
A good way to think about the first expression of what VIX is–a mirror reflection of the volatility regime of the market–is to examine the realized volatility of the S&P 500. This can
be done simply by calculating the standard deviation of the returns of the market and comparing those results with the VIX Index. A simple test should reveal if the VIX Index is anything other than a reflection of that volatility, plus or minus the future expectation of the direction of that volatility.
Indeed, the VIX Index and a basic calculation of realized volatility share a 0.88 correlation and the two data sets are shown together below.
\If the VIX Index were dead, shouldn’t we observe some concerning deviation between the two data sets? Not only do we observe that a strong relationship between the two data sets has held since inception, but also has held through many extreme periods including abnormally high– and low–volatility. Down to the present moment, the relationship reflects a strength which has not dwindled.
Seen from a similar but different method, we examine the same question regarding the relationship between implied (VIX)- and realized–volatility. We can construct a scoring system which assigns a certain number of points to a given daily percentage movement in the S&P 500. For smaller percent moves, we can assign a smaller value than for days when the S&P 500 moves to a larger degree. If we then tally the number of points over a given month, we can compare this alternative approach to calculating realized volatility with the VIX Index. As one might expect, and with a 0.89 correlation, we can observe a strong, persistent relationship exists between the percentage point moves of the S&P 500 and the VIX Index.
In some instances, the VIX overshoots what is justified by the realized-volatility regime due to the supply and demand forces at play. At other times, the VIX undershoots what realized-volatility calls for. In still other instances, the undershoot occurs, but the convexity of the VIX move is so strong that it can still fulfill the hedging purpose for those hoping to profit from such a move.
So, to those who have reported the VIX is dead, it is not. It is doing what it was designed to do–reflect the reality of implied- and realized–volatility present in the markets, plus or minus the supply and demand of those using its related instruments to hedge or to speculate.