VIX Not Just an Indicator Any More
Over the past two years the Chicago Board of Options Exchange Volatility Index, or VIX, has probably become one of the most over-referenced and misunderstood gauges in the financial community. And in an investment world that pays heed to some pretty bizarre and tenuous indicators, that's saying a lot. Still, like cliches being true, tracking implied volatility levels presents a variety of trading and hedging opportunities that can be implemented by trading the VIX-based products directly.
The basic misunderstanding is the view that the VIX is strictly a contrary indicator, and the biggest misuse is in constantly trying to assign or divine predictive meaning from daily changes in the level of the VIX.
For over a year now this has come in the form of citing its low reading as a sign of general complacency that indicates the market is due for a selloff. The fact is the VIX, which has been trending down for over three years and hit decade lows this past February, has never been a good instrument for calling market tops. It is much more effective at flagging market bottoms.
As options guru Larry McMillan, president of McMillan Analysis, points out: "For a measure to provide a contrary signal it needs to demonstrate that all participants are in agreement about the future direction," and right now that is simply not the case.
The VIX has essentially been tracking the historic or real volatility of the underlying index pretty closely for most of the past year. In the last three weeks the VIX has shot up some 30% to 14.55%, it highest level on over two months. But note during this same period the SPX's 20-day historical or actual volatility has risen from 8.10% to 11%, a commensurate 35% increase.
When the VIX hit an 11-year low last February, it coincided with a bottoming of the historic volatility in the index. The fact that the VIX is actually sporting a premium, which should be expected at such low levels, makes it hard to make the blanket statement that the VIX is too low or showing signs of complacency. It makes it especially challenging to choose a directional bias on the underlying index based on a low VIX. If you had been doing nothing but buying option premium or shorting the stocks for the last two years that we've had a low VIX, you've probably had a tough time making money.
But, as most things tend to revert to the mean, an extended period of a low volatility does tilt the odds that volatility will increase at some point. This means buying option premium is now a safer strategy than ever. If the VIX is to be used as a contrary indicator, one must consider that right now it is suggesting that volatility will increase, but it gives no clue as to market direction.
McMillan provides the simple example of a stock or index in which the price changes occur in a 20-day price sequence of 50, 51, 52, 53, 54 ... 69 would have a volatility of just 2.7%, while a sequence characterized by two steps forward, one step back such as 50, 52, 51, 53, 52, 54, would have a volatility of 44%. Even though the second sequence is also a rising market, and would actually have a smaller overall move during the 20-day period, it has a distinctly higher volatility than a market that moves up one, or down, one unit per day.
VIX Futures For the Here and Now
It is now one year since the Chicago Board of Options Exchange launched trading on the
$VIX
futures and it seems a very appropriate time to revisit the subject. Details of the contract can be reviewed in this
past article or
this page on the CBOE Web site. The basic items to be aware of are that the futures contract is called the Jumbo CBOE Volatility Index (VXB) and has a multiplier of 10 times the VIX and is worth $100 per point move. This means if the VIX is at 14, the VXB will be priced at 140 and have a total value of $14,000.
It also means that if the VIX rises 1 point to 15, the VXB's value will increase from 140 to 150, and one VXB futures contract will gain or lose $1,000 per 1-point move in the VIX. Be aware of the leverage involved with futures -- it cuts both ways. As with all futures contracts you will need to open a commodity or futures account to trade this product. And if you really want to get derivative, just last week the CBOE introduced options on the VIX. But with the VIX futures volume still relatively low, and that contract offering significant leverage, I would be wary of trading the options just yet unless you are fairly sophisticated and fully understand the nuances of this product.
Another product more recently introduced by the CBOE is actually slightly more complicated but might be more effective in trading changes in volatilty, rather than simply the direction.
Variance Futures (VT) are based on the three-month price variance and have a contract multiplier of 10,000, which means it's nearly 30% greater or price sensitive than a VIX future.
With the VIX having finally, and somewhat significantly, lifted off an 11-year low, and earnings season just around the corner, there stands a good chance that the stock market will continue to see an expanded daily trading range. This means the time is ripe for taking another look at buying VIX, or better yet Variance futures contracts as vehicles for both speculation and hedging.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to
steve.smith@thestreet.com.