Here Lies The VIX…..

• Posted by Adam Warner
• on January 11th, 2010

Before there EconoStud Peter Orzag…..

Turn away, nothing to see here, the VIX is now as useless as my Giants playoff tickets, says 24/7 Wall Street (hat tip Abnormal).

The CBOE Volatility Index or “The VIX” has turned worthless as a market indicator.  This happens from time to time, and it is often followed by rapid change.  Today the VIX hit a 52-week low of 18.70 and it sits at 19.06 late in the day.  What is interesting is that this was not just a 52-week low in the volatility.  The last time the VIX was this low was August-2008, right before the everyone thought the next wave of the financial markets was upon us.   The iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ) are the two ETF/ETN products which trade around the VIX.

The higher the VIX, the higher the volatility.  I noted that the VIX had started turning worthless back on October 19 when the VIX was hitting steadily in the low 20’s…. It then rose rapidly to over 30 by the end of the month, which corresponded with a 4% drop in the DJIA and a 5% drop in the S&P500 during the same period.  In that article then we gave more explanation because the rally was still fresh, but now it isn’t.

By this logic, when does the VIX ever have any value as an indicator? When the market imploded in late 2008 I saw a raft of articles (mostly off Bloomberg) that pointed to that same low VIX in the summer of 2008 as doing a lousy job predicting the decline. Flash forward to today and VIX at similar levels and we’re told it’s worthless as an indicator for the exact opposite reason.

The VIX really can’t do much more than reflect the reality of the moment, with a dollop of anticipation of the future. In fact about 3/4 of the VIX price can be explained by current realized volatility, the other 1/4 is presumably anticipation (I got this breakdown from Michael Stokes at Market Sci Blog). 10 Day HV in SPY is about 10 right now. That’s low ebb of the range of the last half year, but the midpoint is only around 13 or so. The VIX tends to overprice by about 4 points, so it’s really quite in line right now. The VIX is alive and well as an indicator, and telling you that it believes the market over the next 30 days will continue to plod around or trend slowly like it is now.

Perhaps 24/7 Wall Street needs a refresher course on volatility. Let’s say we have implied volatility of 16 on SPY. Divide that number by the square root of 252 (roughly 16 as well). Now change it to a % (1%). That’s telling you that the “market” expects 68% of trading days in SPY to see a range within 1%. Seems like we’ve seen at least 2/3 days meet that criteria in the last half year. Ergo implied volatility in that range is more than fair.

Yes it would be nice if while the options market sat in this malaise, the VIX exploded. And lo and behold that explosion correctly predicted a market melt. But that really never happens. We do occassionally get the VIX (and VIX futures) overworried about future volatility, but more often than not it’s a contrary tell, and that Fear proves misguided.

So don’t abandom your VIX just yet, just acknowledge that options players and the wisdom of the crowd in general sees the same thing everyone else sees, a whole lot of inaction and slow motion. As well they should.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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