Immediately below is a Wikipedia discussion about the origin, history, development and use of a particular option and exchange traded fund for market volatility, the VIX.
The blog author has an afterword to add to this article, a criticism of this index based on the "CBOE Volatility Index" chart shown below and upon the publication of a "criticism" section near the end of the Wikipedia article.
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The blog author has an afterword to add to this article, a criticism of this index based on the "CBOE Volatility Index" chart shown below and upon the publication of a "criticism" section near the end of the Wikipedia article.
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The idea of a volatility index, and financial instruments based on such an index, was first developed and described by Prof. Menachem Brenner and Prof. Dan Galai in 1986, and first published in "New Financial Instruments for Hedging Changes in Volatility," appearing in the July/August 1989 issue of Financial Analysts Journal. In a subsequent paper, Professors Brenner and Galai proposed a formula to compute the volatility index.
In 1992, the CBOE commissioned Prof. Robert Whaley to create a stock market volatility index based on index option prices. In January 1993, the CBOE held a news conference in which Prof. Whaley introduced the VIX, and, from that date forward, the CBOE has computed and disseminated VIX levels on a real-time basis. Daily VIX levels dating back to January 1986, available on the CBOE website, are those computed by Prof. Whaley based on the history of index option prices. The original article on VIX and its intended uses appeared in the inaugural issue of the Journal of Derivatives.
The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the upcoming 30-day period, which is then annualized. "VIX" is a registered trademark of the CBOE.
Specifications
The VIX is calculated and disseminated in real-time by the Chicago Board Options Exchange. Theoretically it is a weighted blend of prices for a range of options on the S&P 500 index. On March 26, 2004, the first-ever trading in futures on the VIX began on CBOE Futures Exchange (CFE). As of February 24, 2006, it became possible to trade VIX options contracts. Several exchange-traded funds seek to track its performance. The formula uses a kernal-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 goal is to estimate the implied volatility of the S&P 500 index over the next 30 days.
The VIX is calculated as the square root of the par variance swap rate for a 30 day term initiated today.
Note that the VIX is the volatility of a variance swap and not that of a volatility swap (volatility being the square root of variance, or standard deviation). A variance swap can be perfectly statically replicated through vanilla puts and calls whereas a volatility swap requires dynamic hedging. The VIX is the square-root of the risk neutral expectation of the S&P 500 variance over the next 30 calendar days. The VIX is quoted as an annualized standard deviation.
The VIX has replaced the older VXO as the preferred volatility index used by the media. VXO was a measure of implied volatility calculated using 30-day S&P 100 index at-the-money options.
Interpretation
The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period. That is, index options are priced with the assumption of a 68% likelihood (one standard deviation) that the magnitude of the change in the S&P 500 in 30-days will be less than 4.33% (up or down).
The price of call and put options can be used to calculate implied volatility, because volatility is one of the factors used to calculate the value of these options. Higher (or lower) volatility of the underlying security makes an option more (or less) valuable, because there is a greater (or smaller) probability that the option will expire in the money (i.e., with a market value above zero). Thus, a higher option price implies greater volatility, other things being equal.
Even though the VIX is quoted as a percentage rather than a dollar amount there are a number of VIX-based derivative instruments in existence, including:
- VIX futures contracts, which began trading in 2004
- exchange-listed VIX options, which began trading in February 2006.
- VIX futures based exchange-traded notes and exchange-traded funds, such as:
- S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ) launched by Barclays iPath in February 2009.
- S&P 500 VIX ETF (NYSE: VIXS) launched by Source UK Services in June 2010.
- VIX Short-Term Futures ETF (NYSE: VIXY) and VIX Mid-Term Futures ETF (NYSE: VIXM) launched by ProShares in January 2011.
Although the VIX is often called the "fear index", a high VIX is not necessarily bearish for stocks. Instead, the VIX is a measure of market perceived volatility in either direction, including to the upside. In practical terms, when investors anticipate large upside volatility, they are unwilling to sell upside call stock options unless they receive a large premium. Option buyers will be willing to pay such high premiums only if similarly anticipating a large upside move. The resulting aggregate of increases in upside stock option call prices raises the VIX just as does the aggregate growth in downside stock put option premiums that occurs when option buyers and sellers anticipate a likely sharp move to the downside. When the market is believed as likely to soar as to plummet, writing any option that will cost the writer in the event of a sudden large move in either direction may look equally risky.
Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. Only when investors perceive neither significant downside risk nor significant upside potential will the VIX be low.
The Black-Scholes formula uses a model of stock price dynamics to estimate how an option’s value depends on the volatility of the underlying assets.
Criticisms
Despite their sophisticated composition, critics claim the predictive power of most volatility forecasting models is similar to that of plain-vanilla measures, such as simple past volatility.
However, other works have countered that these critiques failed to correctly implement the more complicated models. Some practitioners and portfolio managers seem to completely ignore or dismiss volatility forecasting models. For example, Nassim Taleb famously titled one of his Journal of Portfolio Management papers We Don't Quite Know What We are Talking About When We Talk About Volatility. In a similar note, Emanuel Derman expressed his disillusion with the enormous supply of empirical models unsupported by theory. He argues that, while "theories are attempts to uncover the hidden principles underpinning the world around us, as Albert Einstein did with his theory of relativity", we should remember that "models are metaphors -- analogies that describe one thing relative to another".
Here is a timeline of some key events in the history of the VIX Index:
- 1987 - The Volatility Index was introduced in an academic paper by Professor Menachem Brenner and Professor Dan Galai, published in Financial Analysts Journal, July/August 1989. Brenner and Galai wrote, "Our volatility index, to be named Sigma Index, would be updated frequently and used as the underlying asset for futures and options... A volatility index would play the same role as the market index play for options and futures on the index."
- 1992 - The American Stock Exchange announced it is conducting a feasibility study on a volatility index, proposed as the "Sigma Index." "SI would be an uinderlying asset for futures and options that investors would use to hedege against the risk of volatility changes in the stock market."
- 1993 - On January 19, 1993, the Chicago Board Options Exchange held a press conference to announce the launch of real-time reporting of the CBOE Market Volatility Index or VIX. The original formula for VIX was developed for the DBOE by Prof. Robert Whaley and was based on CBOE S&P 100 Index (OEX) option prices.
- 2003 – The CBOE introduced a more detailed methodology for the VIX. Working with Goldman Sachs, the CBOE developed further computational methodologies, and changed the underlying index the CBOE S&P 100 Index (OEX) to the CBOE S&P 500 Index (SPX).
- 2004 - On March 26, 2004, the first-ever trading in futures on the VIX Index began on the CBOE Futures Exchange (CFE).
- 2006 – VIX options were launched in February 2006.
- 2008 - On October 24, 2008, the VIX reached an intraday high of 89.53.
In 2004 and 2006, VIX Futures and VIX Options, respectively, were named Most Innovative Index Product at the Super Bowl of Indexing Conference.
Michael Harris has argued that VIX just tracks the inverse of price and it has no predictive power as a result
http://en.wikipedia.org/wiki/VIX
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Comments by the Blog Author
The VIX doesn’t tell you whether the market is bullish or bearish, it instead gives a short-term indication of relative volatility as if the entire market were a reflection of the S&P 500 and its derived futures and products.
But the NASDAQ and NYSE markets are not always in gear with the S&P 500. Further, the S&P are peculiarly driven by about a dozen highly traded entities.
Let me mention one other difficulty with this index. It is trend following rather than predicting moves or being exactly correlated real-time to market moves. Take a look at the chart near the beginning of the article.
What can we say about VIX? Note that an extended period of higher volatility was not followed by a spike but by a retreat to historically low volatility. So a temporarily higher "base" predicts – nothing – at – all.
What we CAN say about the VIX is that a market panic that produces an anomalous and high VIX does predict, once VIX descends through 80, a more stable market and a subsequent bull market. But we can already induct this pattern from other less exotic indices.
Summary: Nix on the VIX. It’s late (trend-following), confusing, misinforming, and needlessly complicated.
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