Taking a Ride on the Volatile Side
By Matthew Moran

Illustration By Art Glazer

Introduction Since its introduction in 1993, the CBOE Volatility Index (VIX) has been considered by many to be the world's premier barometer of investor sentiment and market volatility (Whaley, 1993). The VIX Index is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Several papers have suggested that VIX or volatility can be important tools in investors' asset allocation or trading decisions. (See Bowler et al, 2003; Connors, 2002; Copeland, 1999; Hosker and Dholakia, 2004; Rattray and Balasubramanian, 2003; and Traub et al, 2000.)

In response to customer suggestions, a number of key VIX developments recently have occurred. In September 2003 the Chicago Board Options Exchange (CBOE) modified the methodology for VIX so that (1) the new VIX is now based on prices of S&P 500 (rather than S&P 100) options, and (2) the new VIX formula takes into account a broader range of strike prices (rather than using only near-the-money strikes as the original-formula index did). Each strike price is weighted, with at-the-money strikes having the most weight. The new formula is intended to make VIX a better index for investors who manage risks associated with the growing markets for volatility and variance swaps.

The other significant change regarding to VIX has been the addition of new tradeable direivatives products based on the index. In March 2004 the first-ever U.S. exchange trading of volatility-based contracts began as VIX futures were launched on the new CBOE Futures Exchange (CFE). In addition this year Standard & Poor's also began to issue licenses for exchange-listed certificates and warrants linked to VIX.

VIX Prices - Negative Correlation, Mean Reversion, And Market Signal

The CBOE has two indexes designed to reflect market expectations of near-term volatility conveyed by S&P stock index option prices:

· The CBOE Volatility Index (VIX), based on S&P 500 (SPX) options prices, with a new, more robust methodology introduced in 2003, and a price history dating back to 1990.

· The CBOE S&P 100 Volatility Index (VXO), based on S&P 100 (OEX) options prices, with a price history dating back to 1986. The methodology for the VXO Index originally was introduced in 1993.

The VIX and VXO indexes have been pretty closely aligned (note that in Figure 8 their monthly returns have had a 0.94 correlation) and the average VXO price has been about one point higher than the average VIX price.



Professor Robert Whaley of Duke University called VIX the "investor fear gauge," and VIX often has reached relatively high levels at times when there is anxiety among investors. For example, in the past decade, VIX had a daily close above the relatively high level of 43 when investors were concerned about Long-Term Capital Management and the Asian crisis in 1998, the terrorist attacks in September 2001 and the Enron and accounting scandals in the summer of 2002 (see Figure 2).




Figure 3 shows the tendency of the VIX Index to revert to the mean. A Goldman Sachs report (Rattray and Balasubramanian, 2003) noted: "1. Reversion tends to occur after both upside and downside extremes in the New VIX level. 2. Reversion appears to have become stronger recently, both for the long-term and short-term signal, and from both upside and downside extremes. 3. Downward movements in the New VIX after it hits an extreme upside are generally smaller than upside movements after it hits a low level." 


 


One of the most compelling features of the VIX Index is its relationship to the S&P 500 and other stock indexes. As shown in Figures 4, 5 and 6, the VIX Index has tended to sharply increase when the S&P 500 fell rapidly.