What Does a VIX say???

An estimate of volatility? A fear gauge? A measure of hedging? What ?

There’s some stuff you oughta know about the VIX.

1. There is a no-arb relationship between VIX and VIX futures.

S&P 500 futures cannot deviate too far from the S&P 500 because that would present a free lunch for someone out there. All they would need to do is go long or short the futures and offset this with a basket of stocks replicating the S&P 500. The same can’t be done with the VIX. It isn’t possible to replicate the VIX in real-time i.e. by buying and selling the underlying’s options because the weighting of calls and puts used in the calculation changes very fast. Because of this, at least in theory, the VIX and VIX futures are essentially different things and can deviate significantly. Practically, market algos don’t let it happen.

This only goes to show the layers of complexity in the volatility world. Not only because the VIX an approximation of 1-month forward vol, but volatility itself is an unobservable quantity. So the only way to tell if the VIX is doing a good job is to compare it to other approximators of future volatility like GARCH models or what have you. Then, when you go to trade it, the available instruments are not really linked to the VIX by the market forces i.e. the possibility of arb. The way I see it, the VIX tries to tell you what hedger’s think about future vol, and VIX futures try to tell you what volatility trader’s think about future vol. The differences in the two can give some useful information as I discussed in the previous post.

2. VIX options and futures share expiration dates.

This means that the VVIX is actually an estimate of volatility in the VIX futures and not the VIX itself. It’s a subtle but important difference. Put simply, who would be buying VIX options for insurance purposes if not someone with exposure to the VIX futures, which aren’t necessarily linked to the VIX?

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I previously highlighted three ways that you can use a volatility index.

• To gauge one-month forward volatility, albeit with a grain of salt.

• To find a good time to buy vol/hedge portfolio (when inverse correlation with underlying is weak)

• To check if a volatility spike is meaningful (if it is, short-term futures follow the VIX)

If you haven’t read it, you can check it out here:

Three important things to know when using volatility indices

I hadn’t planned to write that post. What happened is I read a two books and a bunch of articles about the VIX which made interesting points, but there was no consensus about what the VIX measures, if it is actually a ‘fear guage’, whether it can be used to hedge, and more. This only fueled my curiosity, and I realized that besides the books, most of the other authors hadn’t done the leg work. I won’t mention anyone because I don’t want any trouble, but the main arguments and my thus-far-informed research are as follows: