I am often frustrated when market commentators use the VIX as though it was the market's "fear gauge." Reporting its level as 19 (or 14 or 27) may be factually correct, but it can be woefully misleading when that single number is viewed as reflecting the level of unease among market professionals.
Anyone who uses a single VIX reading to calibrate bullishness, or bearishness, is making a mistake. The VIX—the CBOE market-volatility index—wasn't developed to provide such a reading. Instead, it's designed to measure the market's expectation of 30-day volatility, using a range of Standard & Poor's 500 index-option prices.
Because options traders are typically willing to pay more for protection during times of financial stress, implied volatilities tend to rise when markets become more uncertain. That leads to higher prices in the options used in calculating the VIX. This correlation between the level of the VIX and market uncertainty is why the index is called the "fear gauge" (a term coined by this column's regular author, Steve Sears).
THE NATURAL QUESTION then is how to best use the VIX without being used by it.
The relationship between implied volatility—expectations of what will happen in the future—and historical volatility—what did happen in the past—is the basis for a significant amount of trading by options market makers and other pros at banks and hedge funds. Historical volatilities, by definition, provide a backward look at the activity of an underlying stock or index. We all know that prior results are no guarantee of future performance, yet historical volatility is frequently the basis for current options pricing.
It's often easier to know where you are going if you know where you have been. If an option expires in 30 days, it's convenient to use the 30-day historical volatility as a starting point. However, implied volatilities are frequently higher than historical volatilities. This reflects the incentive that options sellers require to provide protection and liquidity. Think of it as an insurance premium, if you will. Options on the S&P 500 are subject to this sort of trading behavior, which is directly reflected in the VIX.
In light of the market's recent retreat from its highs, can the volatility index tell us something meaningful about market sentiment? The VIX is currently about 19, just below the 20 level that some people consider a dividing line between bullish and bearish markets. That compares with a 30-day historical volatility reading of roughly 11.5 for the SPX, which represents the S&P 500. Even the SPX's five-day volatility level was only 13. This shows that options traders are willing to pay a significant premium for protection.
SHOULD WE THUS CONCLUDE that the VIX is flashing a warning signal? Not necessarily. The volatility index typically stands at a level well above the SPX's historical volatility. In late March, as the market was inexorably rising, the VIX was at 15, typically considered a low reading. That indicated complacency to many market observers. The SPX's historical volatility at that time, however, was 9. Even in that seemingly placid market, the VIX was telling us that higher volatility was coming…and it did arrive within the month. Although the VIX has risen amidst the choppy markets of the past few days, the current relationship between it and SPX historical volatility is similar to that found in a more sanguine market. Yes, the VIX's elevated reading seems to reflect a higher level of market concern, but the differential is not yet worrisome.
Weathermen and markets both search for foolproof forecasting methods. Use the VIX like a barometer, not a thermometer. Go beyond its current reading to consider whether it is rising or falling and why. The volatility index isn't perfect, but those who understand its purpose can use it to make more accurate market predictions.
STEVE SOSNICK is the equity risk manager for Timber Hill, the options market-making unit of Interactive Brokers.