What’s Up With The VIX?
By: Tony Yiu
Tags: Economics, Investing, Business, Data Science, Finance

What Does The VIX Actually Tell Us?

Anytime you put the word “implied” in the name of a metric like implied volatility, people like to assume the existence of a mystical ability to predict the future.

Yes, the VIX is a crowd-sourced measure of expected market volatility; but in this case, the crowd despite all its “collective wisdom” is not very good at predicting market volatility. Look at the plot below, which compares VIX implied volatility and realized volatility. They pretty much move in lockstep. The key is that the orange line plots the volatility of S&P 500 returns over the PREVIOUS 30 days, not the next 30 days — meaning that VIX implied volatility is highly correlated with backwards looking volatility, not future volatility.

VIX implied volatility (blue) vs. realized volatility (orange)

To hammer in this point, here is a similar plot, except instead of backwards looking vol (previous 30 days), I graphed forward vol (next 30 days) in its place. If the lines line up perfectly, that would mean that VIX does predict future volatility. Instead, what we see is the orange line clearly leading the blue line (for example, the orange line spikes up first before the blue line follows). This is expected, if we could use the VIX to predict future changes in the stock market, we would all be rich (or this benefit would quickly be arbitraged away).

VIX doesn’t predict future volatility

VIX Tends To Move Opposite The Stock Market

VIX is commonly called the Fear Gauge by market pundits. That’s because it tends to spike when stock prices crash (inducing investors to panic). The following scatterplot shows the relationship between daily percentage changes in the S&P 500 and daily raw changes in the VIX — as you can see, there is a strong negative correlation (market goes down, VIX goes up).

VIX moves opposite the S&P 500

Astute students of statistics are probably thinking, “If VIX is a measure of volatility, why doesn’t it also go up when markets spike up?” Great question. Pure statistical volatility doesn’t care about direction, a big move is a big move regardless of if it’s up or down. And yes, a huge and unexpected up move in the stock market would put some upward pressure on the VIX (giving ETFs indexed to percentage changes in the VIX a convex relationship with the stock market).

But overall, VIX’s strong inverse relationship with the market holds due to the following factors:

Big Up Days Tend To Happen In Bear Markets

Big up days in stock markets usually happen in the midst of large drawdowns (like after a few weeks of crashing, stocks take a breather and shoot up 8% in one day). So these big up moves don’t impact the VIX that much because the preceding crash already caused the VIX to spike up. Said differently, usually by the time big up days occur, VIX is already really high and investors are already expecting large moves in either direction.

If big positive days in the stock market started occurring out of the blue during bull markets instead of primarily occurring in bear markets, the observed statistical relationship would probably change. But until then, it remains a hypothetical.

Complacency Vs. Fear

It’s important to keep in mind that the VIX is not a purely statistical construct. It’s a measure of investor uncertainty that embeds the aggregate emotions of market participants as well. To that end, market participants tend to associate rising stock markets with stability, optimism, and certainty causing the VIX to decline. And when markets crash, we are filled with feelings of dread, fear, and uncertainty causing VIX to spike.

The Fear Premium

There is a fear premium baked into VIX, especially when it’s low. Look carefully at the first plot (implied vol vs. previous 30 days realized vol) — when volatility is low (and markets are calm), the orange line tends to be below the blue line. This means that options markets tend to systematically price in a higher level of volatility than that which actually gets realized.

It’s basically an insurance effect. When calculating your insurance premium, insurer’s look at the actual probability of your house catching on fire (based on history and data) and then add a premium to that so that on average they can turn a profit (this compensates them for the risk they take on). The options markets work the same way — investors use options and VIX related derivatives to hedge. In order to motivate people to take the other side of this trade and bear the risk, they need to offer compensation, which comes in the form of a vol premium (the excess of implied over realized). Over time, because the implied probability of a big market move tends to be greater than the actual realized probability, investors willing to provide stock market insurance get paid a premium (in return for bearing substantial risk).

So why does this matter? Well, the size of the premium is a function of two things — expectations about future market volatility (extrapolating the recent past) and the supply and demand for insurance against market crashes. During good times, the supply of insurance goes up because more and more investors view the premiums as easy money (and write put options). At the same time, the demand for insurance goes down because investors get tired of paying for insurance that never turns out to be needed (fewer buyers of put options). This compresses the fear premium (a.k.a. the cost of insurance), putting downward pressure on the VIX when markets are calm or in an upwards trend.