Risk Latte - Fixated and VIXated on Volatility

Fixated and VIXated on Volatility

Rahul Bhattacharya
August 24, 2011

Option traders have long been fixated on implied volatility and other measures of volatility, such as the local volatility or the volatility surface, that are derived from the options prices quoted in the market. Now, it seems that there is a new fixation, the VIX, or, the volatility index on S&P500 stock index. Not only the options traders, but everybody else, from the financial journalists to the market commentators to the regulators, it seems, is now talking about the VIX index. Justin P., my friend and a long time options trader, recently lamented to me over the phone that we are now VIXated on volatility.

VIX is a volatility index computed from the options prices on S&P500 stock index. However, most investors, including some very sophisticated ones, think of VIX as simply the “fear gauge”. They believe that a high value of VIX signifies heightened worries of the option traders about an impending market crash or a significant rally. The reason for this is the somewhat erroneous interpretation on the part of these investors, and the broader public in the financial markets, that VIX measures the expected future volatility in the stock market (S&P500 index). If you had listened to the commentary on financial television for the past two weeks then you may have come out with the impression that VIX captures the expected movement of the S&P500 in the next one month. A VIX value of 41, for example, would more or less signify that S&P500 index is expected to move up or down by 11.83% in the next one month (this number is arrived at by dividing 41% by the square root of 12). Many traders and risk managers still think that since VIX is derived from liquid options prices on S&P500 stock index it somehow captures the implied volatility of at the money S&P500 options. Nothing can be further from the truth.

As Pablo Tirana, the veteran options trader explains, that even though VIX is computed from liquid option prices on S&P500 index, it is neither about implied volatility derived from these option prices nor is it about expected volatility of the S&P500 index. His argument is that the best way to interpret the VIX, which is linked to S&P500 option prices across a large range of strikes, is as a measure of the level of volatility smile at any one point in time. In option parlance, a "smile" is plot of implied volatility across strike prices for a particular maturity. If the X axis represents strike prices of options for a particular maturity, say, 30 days, and the Y axis represents the implied volatility derived from these options then the XY plot will be that of a flattened parabola if the out of the money and in the money options have higher implied volatility than the at the money options, somewhat like a smiley face. According to Tirana, an increasing VIX signifies, on an average, a "happier" smile (of the S&P500 options) and a falling VIX signifies, on an average, a "sadder"smile.

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