CBOE VOLATILITY INDEX (VIX)
APPLICABLE TIME FRAME(S):
SHORT / INTERMEDIATE
UPDATE SCHEDULE:
Each weekday night by 7:00 PM EST
EXPLANATION:
The VIX measures the implied volatility (i.e. estimated future volatility) of near-term at-the-money SPX (S&P 500) index options (click here for an excellent overview of options by the CBOE).
If the SPX moves significantly, new strike prices are used to calculate the VIX. Since there is a skew to options prices and implied volatility changes with the strikes, the VIX will typically rise when the market drops and fall when the market rises. This is not always the case, but the correlation is clear.
The common interpretation of VIX movements is that the VIX will rise when fear or uncertainty does, since there will be a greater demand for put options. Conversely, when the market is rising, that typically creates complacency on the part of traders and the VIX will fall as the demand for put options decreases.
GUIDELINES:
Instead of being focused on the absolute level of the VIX, we prefer to use Bollinger Bands to define our extremes, which shows us how extreme the VIX is compared to its average over the past quarter. If the VIX goes outside of one of the bands, we know that it is two standard deviations away from its mean value of the past three months - truly an extreme event - any usually a precursor to a market reversal.
We also include a measure of the "volatility of volatility", which is a 21-day historical volatility of the VIX itself. Looking at the data this way can often give us more accurate signals than watching the VIX, as it tells us how quick traders are to change their opinions of future volatility.
When they see no need to change their outlook, then we might assume that they are becoming complacent. In that case, the historical volatility of the VIX will contract (i.e. the indicator on the bottom pane of the chart will exceed the red trading bands), and often a market decline will follow.
ADDITIONAL RESOURCES:
Chicago Board Options Exchange (www.cboe.com)
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