Tracking Volatility with the VIX Index

Volatility, as measured by the VIX Index, has fallen to 17.5% so far in 2010. Often referred to as a “fear gauge,” the VIX moves up as investors buy bearish options (puts) on the S&P 500 and down when investors sell these options.

The VIX tends to drift between 10 and 20 under normal circumstances, but moved above 80 following the Lehman Brothers bankruptcy in November 2008. Since then, the VIX has returned to more historically normal levels – today it sits at 17.9 compared to the historical average of 20.3 – for several reasons.

For starters, there is a lack of participation in the options markets by institutional investors who are afraid of getting trapped in the event of a quick market movement – a symptom of the scars from the credit crisis. Internal risk management systems are also limiting banks from facilitating options trades as the return of capital trumps the return on it.

And we can’t ignore the influence that vast amounts of liquidity has in driving down volatility while pumping up risky assets such as stocks or corporate bonds. Other policy responses to the crisis have reduced price swings too. For example, the Federal Reserve bought up to $1.25 trillion in mortgage-backed securities (MBS) sold by agencies Fannie Mae and Freddie Mac, basically meaning that the Fed is the market for such debt. No surprise such a big buyer would help keep volatility under wraps.

Increased volatility could spell trouble for equities, but don’t become fixated on the VIX in hopes of predicting the market’s future direction. While options activity reflects market participants’ expectations of future market conditions, their outlook and sentiment can change at a moment’s notice.

A widely publicized study released this month by Birinyi Associates showed that the VIX “is a measure of current volatility with little or no predictive or indicative value regarding the course of the market,” but the study does suggest that high volatility may be a contrarian indicator. Birinyi Associates concluded that the contrarian value of low volatility is less clear.

This Wall Street Journal article suggests that the futures contracts on the VIX may be a better gauge for predicting stock market moves. This means that investors should be bullish when the futures are significantly lower than the VIX and bearish when futures are higher. Data from Bloomberg shows that July futures on the VIX are trading at 23.25, August futures at 23.40, and September futures at 23.60 – all considerably higher than the 17.91 level today, but still not what I would consider crisis levels.

What could be pushing futures on the VIX higher?

The Fed’s MBS purchase program ends this month, which could very well allow volatility to pick up again. Other looming concerns such as rising government debt levels or a potential overheating in Chinese markets could also provide impetus for bigger price swings. VIX futures may also be pricing in a pullback in the stock market following the strong run we've had over the past five weeks.

It’s hard to imagine the VIX continues to trend lower, but the pick-up in volatility that futures are predicting is relatively minor and not worth losing sleep over.
Peter Lazaroff, Investment Analyst