VIX is a widely followed indicator of market volatility. Formally, VIX is known as the Chicago Board of Options Exchange (CBOE) Volatility Index. Informally, VIX is known as the “fear index” because volatility almost always increases when prices fall. High readings of VIX are widely assumed to show high levels of fear. Low levels of VIX are associated with investor complacency.
VIX was developed by the CBOE in 1993. To calculate VIX, the CBOE measures the 30-day implied volatility of a number of different options contracts on the S&P 500 index (SPX). The value of VIX at any given time represents the implied volatility of a hypothetical at-the-money SPX option with exactly 30 days to expiration. The value of implied volatility is found using options pricing models like the Black-Scholes model.
VIX uses real-time data from the markets to measure volatility and is therefore an indicator of what traders are doing with their money at any given time. When VIX is high, traders are paying a high price for protection against losses in the options markets. In theory, they would only agree to pay a high price for protection when they are concerned about losses over the next 30 days.
By quantifying the level of fear in the market, VIX is the only measure of market sentiment based on what traders are doing rather than what they are saying. Traditional sentiment measures are based on surveys. For example, the American Association of Individual Investors (AAII) publishes a weekly Sentiment Survey that shows the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months. Investors Intelligence conducts a similar survey of newsletter writers each week. While surveys offer valuable information, they are only available weekly and offer only a snapshot of market opinions at that time. VIX measures sentiment moment-by-moment and intraday changes in VIX show the rise and fall of fear in the market over the course of a day, or over the course of a longer period of time.
In theory, VIX goes up when stocks fall and VIX declines when stocks rise. The chart below shows that theory holds up well in the real world. High levels of VIX (the orange line) have been seen at a number of major market bottoms. The stock market is represented by the S&P 500 index (SPX) which is shown as the blue line in this chart.
To confirm the visual relationship between VIX and SPX, we can use a regression analysis. Linear regression is a statistical technique used to quantify the relationship between two variables. In this case, the two variables are the daily percentage changes in VIX and SPX. One of the products of a linear regression is the correlation coefficient which is a statistical measurement of how movements in one variable (VIX) are related to movements in the other variable (SPX).
Correlation coefficients range from -1 to +1. Perfect positive correlation (a correlation coefficient of +1) would mean that the two variables always move in the same direction. A perfect negative correlation where the correlation coefficient is -1 would mean the two variables always move in the opposite direction. A correlation of 0 indicates the relationship between the two variables is completely random. In the stock market, we would never expect to see a perfect correlation but correlations above 0.70 or below -0.70 can be significant.
The next chart shows the correlation between the VIX and SPX, as calculated by the CBOE. Although the precise value varies from year to year, the relationship between the two indexes is strongly negative. The correlation coefficient has varied from -0.75 to -0.86. This provides statistical confirmation that we should expect SPX to rise when VIX falls.
Related:
