Understanding Volatility and the VIX “Fear Gauge”: QuickTake

Basically, the rise and fall of prices in financial markets. Downward moves tend to attract more attention and be more associated with volatility, as they also tend to fuel worries about what’s next.

The most important tracker is the Cboe Volatility Index, or VIX, which is sometimes called the “fear gauge” because it tends to rise when stocks fall. It is a market estimate of future volatility.

3. How does the VIX capture fear?

It is compiled based on how much traders are willing to pay for options on the S&P 500 Index. Options are contracts that give the holder the right, not the obligation, to buy securities at prices determined on a specific date when the underlying asset reaches specific levels; traders often use options and other derivatives as insurance policies against market fluctuations or to bet on movements themselves. The higher the option price, the higher the fixed cost, and therefore the greater the movement needed to generate a return that will make it profitable. Thus, option prices reflect the size of the fluctuations – the volatility – that traders expect. Suppose a trader pays $5,000 for an option betting on the movement of the yen and the contract shows the implied volatility to be around 8%. If another investor pays $10,000 for the exact same option, the level of implied volatility jumps to around 10%.

4. What is “normal” for stock volatility?

The long-term average of the VIX is around 19.5 and its median around 17.6, with its lowest levels between 8 and 10. Its intraday high is 89.53, set on October 24, 2008 , at the height of the global financial crisis. On March 16, 2020, it closed at an all-time high of 82.69. Some call the VIX “mean reversion” – it tends to move back towards its mean over time rather than staying at the extremes.

5. How do people invest in the VIX?

They cannot invest directly in the VIX, which is just a number, but can bet on the evolution of the index using futures, options or exchange-traded securities based on the VIX. In fact, the emergence of a whole host of VIX-related products in recent years has led to questions about whether VIX trading itself influences the index or volatility as a whole.

6. Is volatility trading like stock trading?

They have similarities including the ability to go short or long. “Short volatility” is a bet that volatility will continue to decline, or at least stay at very low levels. “Long volatility” is the opposite, a bet that it will rise.

7. Is there a lot of money invested in volatility?

Apparently yes. In addition to the amount invested in VIX derivatives and exchange-traded products, many investors use strategies that depend on volatility. A 2018 paper estimated that the invisible hands of volatility-sensitive investors controlled over $1.5 trillion. They include hedge funds, mutual fund managers, risk-matching funds, banks, broker-dealers and market makers, according to JPMorgan Chase & Co. in market moves and an implied bank put central, or a promise to put a floor under the markets during the turmoil.

8. What’s wrong with that?

As long as market fluctuations remain under control, these players continue to buy. But when a volatility shock hits, they start selling, and the higher their positioning, the faster they unload. The problem is that dealers and market makers – those tasked with absorbing these flows – also react to changes in volatility. When it is high, these intermediaries widen bid-ask spreads to reduce their risk. This self-reinforcing cycle – what some in the market call a catastrophic loop – could help explain the link between seemingly indiscriminate selling, low liquidity and the violent chills that rocked assets as pandemic fears escalated. spread at the start of 2020, extending far beyond the stock market.

9. What does this correspond to?

Markets could be vulnerable to a “correlated asset market crash.” This is what Vineer Bhansali and Larry Harris predicted could result from the rise of trading bets against price fluctuations in the 2018 paper. According to JPMorgan, equilibrium can be restored, but only when prices reach a level where players insensitive to volatility – such as pension funds, insurance companies and sovereign wealth funds – come into play.

10. What broader factors influence volatility levels?

Fundamentals and market mechanics are two major factors in volatility levels. Daily news that affects markets as a whole will also affect volatility, such as a geopolitical event or earnings reports. Things like clarity – or lack thereof – on Fed policy can also influence it, as it influences traders’ confidence in what the situation will look like in the weeks or months ahead. The Fed’s preparation for likely rate hikes this year has particularly increased rate volatility, as measured by the ICE BofA MOVE Index, which tracks movements in Treasury option prices.

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