Why the measure of volatility on the S&P 500 is as important as ever.
Any words that contain the letter “x” are quite rare and inherently strange. There is Xenophobia, which is the fear of people from other countries. There is Xenitis, which is a mix of the flu and the common cold, clearly not a good thing in a Covid-world. And there is even Xaern, which means you enjoy something so much, you begin to hate how much you enjoy it.
Yes, the X that is used in symbols of skulls and bones really does have a rather negative connotation, through no fault of its own. Financial derivatives suffer from the same fate - often perceived as evil reincarnate or weapons of mass destruction that are deployed by evil speculators seeking to enrich themselves. Putting all of that together and you have the VIX index, which measures the volatility of the S&P 500.
It is a market like any other, and people will buy or sell the index at a price that they deem to be fair. Simple supply and demand, just like buying Vodafone, Sterling, Gilts, or orange juice futures. Moreover, we have models to tell us what is the fair price for the index. After all, a financial derivative is nothing more than something that depends on the price of another. What makes the VIX index so important, is that it is used as a measure of risk in the market. And not just any market, but rather the most important of them all, the mighty, all conquering and all significant index of the largest companies in the United States of America.
So, what’s the problem? For one, people are often confused with the price. Volatility is a statistical measure and is quoted as the standard deviation of the annualised returns for a given period. Crudely speaking, a VIX price of 16 implies that people expect the S&P 500 to move by 1% per day for the next month. Even more simplified, when the VIX is at 10, things are good, when the VIX is above 30, things are bad. In March, the VIX index jumped to 90, which would imply that people expected the S&P 500 to move up or down by 5.6% per day, every day, for the next thirty days. That’s a lot of volatility, no pun intended.
The bigger problem though, is that the VIX moves much more than the underlying index. Whereas we might get into a panic because the market fell by 5%, imagine buying the VIX index at 90, and then seeing it drop back down to 30, because you know, the panic was over by April. Well, then you would lose 66.6%, which is not only the sign of the devil, but would make for a very bad day at the office indeed. Hence, proceed with caution when trading the VIX index, but do keep an eye on it, as X marks the spot where a lot of very valuable information is buried.