The ABCs of the VIX

I am one of those cheapskates who buy Christmas ornaments by the bucketload from Costco in January for ten cents on the dollar because my 11-month theoretical return on capital comes close to 1,000%. 

I also like buying flood insurance in the middle of the summer drought when the forecast in California is for endless days of sunshine. That is what we had at the end of July when the (VIX) was plumbing the depths of $12.

Get this one right, and the profits you can realize are spectacular.

It gets better. 

If the bottom in volatility exactly coincides with the peak in the stock market that it measures, volatility could be headed back up to the 30% handle, and maybe more. 

I double dare you to look at the charts below and tell me this isn’t happening.

Watch carefully for other confirming trends to affirm this trade is unfolding. Those would include a strong dollar, and a weak Japanese yen, Euro, and rising fixed income instruments of any kind.

Notice that every one of these is happening this week!

Reversion to the mean, anyone?

You may know of this from the many clueless talking heads, beginners, and newbies who call (VIX) the “Fear Index”. 

For those of you who have a Ph.D. in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of option contracts on the S&P 500 index (SPX).

The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front-month and second-month expirations. 

The (VIX) is the square root of the par variance swap rate for a 30-day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever-useful Black-Scholes equation. 

You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?

For the rest of you who do not possess a Ph.D. in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don’t know what an SAT test is, this is what you need to know. 

When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. Period. End of story. Class dismissed.

The (VIX) is expressed in terms of the annualized monthly movement in the S&P 500 (SPX) which, with the (VIX) today at $10, is at $72.54. 

So for example, a (VIX) of $10 means that the market expects the index to move 2.89%, or $72.54 S&P 500 points, over the next 30 days. 

You get this by calculating $10/3.46 = 2.89%, where the square root of 12 months is 3.46. 

The volatility index doesn’t really care which way the stock index moves. If the S&P 500 moves more than the projected 2.89% in ANY direction, you make a profit on your long (VIX) positions. 

I am going into this detail because I always get a million questions whenever I raise this subject with volatility-deprived investors.

It gets better. 

Futures contracts began trading on the (VIX) in 2004 and options on the futures since 2006. 

Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the “hedge” in hedge fund.