Many traders, both novice and professional, like to opine on the
current levels of the VIX, the CBOE Volatility Index, as signaling
extreme market complacency and thus the cue for a market decline of
Unfortunately, the VIX is a sufficiently complicated
mathematical animal that most of those offering opinions don't
really know what they are talking about. After you read this
"must-know" stuff about the VIX, you will know more than most of
them and be able to slice through or simply ignore their
1) Standard Deviation:
Volatility for options traders is always expressed as annualized
standard deviation. That means a VIX of 12 says that "the market"
(S&P 500 options traders and institutional equity hedgers)
expects the index (SPX) to be within 12% higher or lower, one year
from now, in about 68% of cases. In short, it is a probability
2) Implied Volatility:
The VIX is constructed from the "implied" volatility of SPX
near-term options traded at the CBOE. Implied volatility is
produced by running the Black-Scholes options pricing model
backwards by inputting an options price to see what volatility it
"implies" instead of inputting an expected volatility to see what a
fair value price for the option should be.
3) The Price of Risk:
Volatility for options market makers and institutional hedgers is
the price of risk, much like insurance. The SPX option market
makers are "dealers in insurance." The market makers hedge their
risk with institutional cash index baskets, futures, and/or other
options. They want to profit from buying perceived low volatility
and selling perceived high volatility. But their time frames are
short-term, from hours to a couple of months.
4) Market Maker Business:
To convert the VIX to a daily volatility number, simply divide by
16%. For example, a VIX of 12% divided by 16% = 0.75%. This means
that the VIX is "pricing" about 0.75% daily volatility. A VIX of 16
would imply 1% daily volatility. This is roughly true because "vol"
is proportional to the square root of time and 16 is the
approximate square root of the number of trading days in a
This is important because option market makers have to price and
hedge SPX options on an hourly, daily, and weekly basis in a very
competitive business environment. The VIX therefore reflects not
only institutional expectations about volatility and risk over the
next 1-4 weeks, but also the market makers' daily business
5) A VIX of 10 is Normal Now:
30-day historical volatility for the SPX just dropped to 7% in this
quiet market. That implies daily volatility of under 0.45%. A VIX
of 11 implies daily vol of about 0.7%. The VIX probably won't go to
7 as its function is pricing the anticipated risk of the coming 30
days, but I wouldn't be surprised if it creeps down to 9 as equity
markets quietly grind higher.
6) VIX Doesn't Trend, It Drifts & Jumps:
My final sin of VIX bloviators is when they try to tell you that
the chart is forecasting a certain move. Anybody who puts moving
averages, patterns, and other technical analysis on the VIX truly
doesn't understand it as a fluid function that mathematicians call
a "stochastic" process. When the VIX isn't jumping to re-price
risk, it is drifting, decaying, being bought and sold in
relationship to the underlying actual volatility of the SPX
7) VIX-Based ETPs Are Dangerous:
Because the VIX is such an unique mathematical function -- and not
a conventional security like a stock, bond, or commodity whose
price is based on market perceptions of value (and which can
theoretically go to zero or infinity) -- its derivatives can be
even more slippery to understand and make use of. Here's the gist
of what I told one trader recently on StockTwits who was trying to
make predictions about the S&P 500 index based on the price
movements of VXX, the iPath S&P 500 VIX Short-Term Futures
"Since you are suggesting that a derivative (VXX) of a
derivative (VIX futures) of a derivative (the VIX index) should
have strong predictive power about the S&P 500, you have proven
you do not understand options volatility, the VIX, futures, ETPs or
nearly all derivatives."
The leveraged ETPs like UVXY and TVIX are even more
dysfunctional products as they are perpetual victims of VIX futures
"contango" (Google it) that should be banned by the SEC. XIV and
SVXY, the ETPs that short volatility, may still be very useful,
though not without some risk just like any derivatives.
Who Am I to Say?
What are my qualifications for offering such criticism and
advice about volatility "speculators?" Though I was not an options
professional myself, I worked for and learned from some of the best
option market makers in the world at the CME and the CBOE,
on-and-off from 1994 to 2010.
Many of them had roots going back to the formation of
standardized option markets in the early 1970s and they knew
Fischer Black, Myron Scholes, or Robert Merton. Some even wrote
practical handbooks for option professionals, like Shelly
Natenberg, my first real-world classroom teacher on these
If you really want to understand "
Option Volatility and Pricing
," then pick up his book on Amazon. It will teach you everything
you need to know -- short of having a pro teach you in the real
Next time, I'll discuss the limitations of volatility -- i.e.,
standard deviation -- in adequately measuring the risks in
financial markets. That subject is covered quite well in Nassim
Taleb's 2007 book "The Black Swan," which was published before the
VIX even imagined it could go to 80 in the 2008 crisis. But I can
save you 250 pages of boredom if you are not into the history of
Bottom line: Unless your friends are option market makers,
beware friendly advice about volatility.
Your VIX advisor,
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