We have heard a lot that the fear or volatility index (the VIX) has been unreliable lately since it has been rather quiet. Certainly, is this really the case? Can this have any impact on the volatility analysis? And why is it less dynamic?
The Fear Index
The VIX or Volatility Index (technical name) is more commonly known as the Fear Index. It goes up when anxiety and uncertainty increase in the markets, and vice versa, it goes down in the opposite case, in an overly optimistic situation.
It is a sentiment tool much observed by traders. It is more often used as a contrarian tool. Therefore, operators will mainly use it to define the following points:
1/ Buy when others are afraid
2/ Sell when others are too greedy (greedy in English)
Generally, operators will mostly hedge when the damage is already done. It is a tool for measuring market sentiment much like the famous “fear and greed index” that is used for both traditional and crypto markets.
The most common strategy for using the VIX
Based on the most common usage technique, as mentioned earlier, we can see the performance of the S&P 500 stock index after buying different levels of the VIX. Performance being best when buying with a VIX above 30, then selling below 20. This strategy would have outperformed the buy-and-hold strategy in 2023 for example.
Of course, and as in all investment strategies, there is no 100% effective technique, only strategies based on probability. Therefore, it happens that the level of the VIX continues to rise much higher than shown on the previous table. Mainly in the case of a major catalyst like a blackswan or black sign, this is the case of COVID 19 or the case of Lehman Brother bankruptcy. These are rare but extreme cases.
It also happens that the volatility index does not reach 30 levels for several consecutive years as well.
Therefore, one strategy is not always effective in all contexts. So you have to know how to adapt to the evolution of the markets and the context.
The more technical explanation of the VIX
First, it is important to remember the more technical version of the volatility index. This is simply the implied volatility of S&P500 options over 30 days. To do the math, there are going to be option expirations between 23 and 37 days to establish the 30-day volatility.
When there is greater demand for options to hedge, there will be a rise in the VIX since demand can exceed supply. So option sellers will sell more and more expensive options. This is where we have the principle of supply and demand. A price increases if demand is increased relative to supply. It is also the reverse case. When the supply exceeds the demand, the price of the options will fall, and therefore the VIX will remain at lower levels.
Description of a call or put option
Options are derivative products. The purchase option or a call is a contract which gives the holder the right and not the obligation to buy the underlying at a price and on a date determined in advance. On one side is the seller of the call option and on the other side the buyer of the call option. The put or put option is a contract which gives the holder the right and not the obligation to sell the underlying at a price and on a date determined in advance. And it’s the same, there is the one who sells the put option and the one who buys the put option. Options are used to hedge (protect a portfolio), speculate (take advantage of leverage) or sell volatility. You can buy or sell options.
The MEME mania effect
Since 2020, there has been an explosion in the use of options. And as 2022 has been full of volatile moves, traders headed for 0 expiry options. An option with expiration 0 means it expires the same day. It is clear that traders are looking for quick short-term profits rather than investing for the long term. It became the new MEME. It is obvious that derivatives also have an impact on intraday movements accentuating upward and downward movements.
We can see on the graph below the increase in the volume of options with expiry 0:
With the lack of visibility, tensions surrounding inflation and the Fed’s monetary policy, operators favored the very short term. However, even though the volume of options has exploded, the VIX has not moved much. This is mainly due to the fact that the expirations taken into account in the VIX are between 23 and 37 days and not 0 days. Therefore, this explains why the VIX has been quieter lately and but this is not necessarily the end of the VIX.
The other explanation also comes from the fact that institutional investors were mostly cash. The key rate hikes made it possible to offer higher interest rates without taking the risk of losing capital. It remains an incentive. This is even more the case in an environment where there is little visibility, a very uncertain environment. If the institutions have nothing to cover, it is normal that they will not buy options with a longer expiration. Therefore, this is also reflected in the VIX.
Is this the end of the VIX?
This is not the first that we hear that it is the end of the VIX or that it is dead. Markets change and sometimes things don’t follow an absolute rule. Does this mean that we can assume that the VIX is finished? Of course not. It is moreover often when this one is put aside that it can finally surprise. It only takes an unexpected event like a black swan for the VIX to wake up again and again.
On the other hand, it is important to specify that the year 2022 was a bearish year because there is a deep correction in US bonds. Bonds move inversely to interest rates. That’s why we say that 2022 was a bond bear market.
If we take the volatility index for bonds MOVEwe can see that it has grown significantly compared to the VIX.
Last little thing, when institutions will again exchange cash to buy shares, it will also mean that they will have to buy options to cover themselves. Therefore, it risks powering up and waking up the VIX again.
Conclusion
There is continual evolution within the markets. The interest and the popularization of the options made it possible to find alternatives. Traders favored short expiry options in an uncertain environment. The same is true for institutional investors who favored cash so as not to need to hedge positions. The environment is changing, and it’s still too early or immature to confirm or say it’s the end of the VIX.
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