The VIX is a volatility index that uses the implied volatility of a wide range of S&P 500 index options to provide a picture of the market’s expectation or projection of 30-day price variance. Historical volatility is the measure of price variance that has occurred in the past, while implied volatility is a consensus projection for the futures. Implied volatility is the chief determinate when it comes to the prices of put and call options. Options are price insurance, and the price variance measure is the critical input for estimating the odds of price moves higher or lower over a period.
While history tends to repeat itself, it is never a guaranty of future performance. Many option traders consider historical volatility levels when pricing puts and calls through their estimation of future price variance. There are times when historical volatility for a period is the same as implied, but at others, the differences can be significant. A sudden move in an underlying asset can cause implied volatility to spike. Since markets tend to take the stairs up and the elevator down, volatility can often spike higher during price corrections to the downside. The VIX index was trading at the bottom of its long-term range last year sometimes falling, at times, below the 10 level. On February 6, the measure of price variance in the S&P 500 index spiked to the highest level since 2008 when it rose above the 50 level as all of the leading equity indices corrected sharply from highs.
As the chart shows, the VIX closed at 29.06 on Friday, February 9 which is a level that the volatility index had not reached since 2011.
The rise of the VIX is a sign. It tells us that the most market participants looked to the options market to hedge or protect existing positions, and to position for a continuation of volatile conditions in the equities market. The VIX had been edging higher before stocks began their correction which was an omen for the equities market.
From February 2016, any dip in the stock market turned out to be a buying opportunity, and the market made a series of new highs. Since the beginning of 2017, the principal indices in the U.S. made a series of new highs, and the market became accustomed to the bullish conditions that favored investors with a buy and hold mentality. The average CAPE ratio, a measure of average valuations in the S&P 500, rose to over 33 times earnings recently, which was the second highest level in history. However, the rise in the VIX told us that trading, rather than investing, will have its day in the sun over coming months. If this continues to be the case, nimble traders moving in and out of long and short positions will achieve optimal results. The last time the VIX closed below 10 was on the first trading day of this year and it has not looked back. When the VIX moved above 22.51, it broke a pattern of lower highs, and we have seen lots of volatility in stocks, and markets across all asset classes.