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The VIX measures the implied volatility (i.e. estimated future volatility) of near-term at-the-money SPX 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 SPX 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.
Volatility is mean-reverting, meaning that periods of high volatility tend to follow periods of low volatility. There are many ways to monitor these cycles, and the VIX is one of the better ones. For a longer-term perspective of how much uncertainty the VIX may be pricing in, we can look at how far the 10-day average of the VIX is stretched from the 200-day average.
However, if we want to see just how extreme it is on a standard deviation basis, then we are presented with a serious problem, and it's a common one for sentiment measurements. The problem is that many sentiment indicators, the VIX in particular, have a very high statistical skew. You don't need to have an understanding of statistics to see that the VIX often has very high spikes higher, but very few spikes lower.
The following table presents the total number of occurrences of the VIX exceeding one or two standard deviations on a closing basis from 1986 - 2003:
We can see that it exceeded its upper standard deviation band (i.e. +1) a total of 521 times. It exceeded its lower band 548 times. This is relatively close, and should be expected if we have a normal distribution. However, and this is where the problem comes in, the VIX exceeded its 2nd upper deviation band 152 times, but NEVER pierced its 2nd lower deviation band. With this great of a skew, it basically renders the idea of standard deviations useless.
Fortunately, there is a way to correct for this phenomenon, which is where this indicator becomes useful. This indicator measures the distance of the 10-day moving average of the VIX from the 200-day average, then transforms that data to correct for the skew inherent in such readings.
The statistics behind the indicator are not particularly important, but the concept is - when the VIX gets to the +10% level, it is oversold (and the market overbought) in a statistically meaningful way. Conversely, a reading below the -10% level suggests the VIX is overbought (and the market oversold). This allows us to determine the degree of overbought/oversold without the distorting effects of the traditional skew of the indicator.
When the indicator reaches its upper extremes, the market very often has a difficult time making headway on the upside. When it reaches the lower extremes, the market environment tends to be positive for equities. Again, using the +/-10% level is an effective marker of extremes, with the +/- 15% level effectively serving as "maximum".
The following chart details two examples of the use of this indicator. Entering the Spring of 2001, the market had been chopping lower and was finally beginning to see some heavy, persistent selling. Eventually, that selling created a large amount of fear among options traders, as the 10-day average of the VIX began to rise significantly over its 200-day average. It entered extreme territory in early March, but became truly notable in the later part of the month.
At the end of March and early part of April, the VIX Transform was at "maximum" oversold, which lead to a nice rebound in equities soon after. By the time the rally got fully underway heading into summer, the Transform switched course and became overbought to a high degree. As you can see from the example below, that was not a period where one would want to concentrate on long positions.
Although this is a real example and points out the value of following this information, we do not mean to intimate that the market ALWAYS peaks when there is a high VIX Transform reading, or troughs immediately after the indicator touches its lower levels. It is a guideline and not a trading system unto itself.
*Standard Deviation. See below...
68% of readings (1 standard deviation) should be between -10% and +10%
95% of readings (2 standard deviations) should be between -20% and +20%
99% of readings (3 standard deviations) should be between -30% and +30%
In other words, we should expect a reading under -20% or over +20% approximately 13 times per year. Since such a reading would be relatively unusual, it suggests that we may be seeing an unsustainable trend.
Chicago Board Options Exchange (www.cboe.com)
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