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Using the VIX Index as a market forecasting tool

 

The VIX Index, also known as the “Fear Index”, is one of the most watched indices in the markets. The VIX Index is a measure of Volatility in the markets. You’d be forgiven if you believe that the VIX should go up when the markets are volatile, on the upside or the downside. But this is not the case. The VIX actually goes up when the markets go down, and goes down when the markets go up. (See Figure below – correlation between the VIX and the S&P 500 Index (SPX). Whenever there’s an element of panic or crash in the markets, the VIX spikes up. In 2008/2009, it reached an all time high of 96 when the markets were at the lowest – SPX reading of 666. Since then its come close to 50 two times, once in 2010 and once in 2011, both when markets seemed to be crashing. So the SPX and the VIX are inversely correlated. But the VIX index is not a true “volatility” indicator, its a “fear” indicator.

 

 

 

 

Exactly how the VIX index is calculated will be the topic for another post. In this post, the goal is to try and use the VIX index as a forecasting tool for where the markets may be headed in the medium term (4 to 6 months). And we do this by analyzing the VIX Options in Figure II below, and understand where all the big players or the “smart money” players are positioned for the next 4 months. The graphic shows the Jan 2013 Option chain for the VIX index. On the left side you have the Call Options and the right side are the Put Options. Also shown is the Open Interest for both Options. Strike prices are shown in the middle. 

 

 

 

 

There are a few observations we can make here - 

 

1) The Open Interest on the Calls side is much higher than the Puts side, and it also spans a much larger range of strike prices on the Calls side. The VIX Index itself is at 14 today, and the smart money players have large Call positions starting from the strike price of 23 and goes all the way to 45 strike. This is the first indication that tells you that the smart money players are expecting the VIX index to rise to 20 or 25 or 30 or more in the next 4 to 5 months. If the VIX index rises, the SPX will fall. 

 

2) The second and more interesting fact is the premium amounts for these Options. The index is at 14 today, so the At the money (ATM) Options are at 14. The ATM Puts at 14 strike price are going for 25 cents, but look at the ATM Calls. They are going for $7.15. In general in all stocks and index options, the ATM Calls and Puts are somewhat equal. This makes sense because the likelihood of the stock going up or down at any given time is 50-50. But the ATM VIX Calls are priced 30 times that of the Puts. This is again another indicator that there is serious demand for the Calls and not much for the Puts. This again means smart money is expecting the markets to go down in the 4 months by quite a bit. 

 

3) Third interesting point – on the Puts side, look at the strike price of 12 or lower. These Options are virtually going for nothing, 2 cents or 5 cents. This means smart money thinks there is no chance of the VIX index going below 12, so we are very near to a market top right now. 

 

4) The 14 Put is going for 25 cents. To find the corresponding Option on the Calls side for 25 cents, we have to go all the way to the 50 strike price. 

 

The Smart Money is clearly positioned for the VIX to increase in the next 4 months. This means markets will be coming down. Nobody knows what will happen, but at least we can see how the big players are positioned here. 

10 Comments

  • Hi hari, manu tkx.
    Nonetheless, I raise a question. The fact smart money is skewed to vix calls isn’t only pure anticipation on the future vix direction. The reason is also it’s cautious to hedge gains, or prevent/protect portfolios. Call on vix is equivalent to put on S&p500. Hence, we find on vix options the traditionnal skewness between calls & put.

    • Phillip, totally agree. It is definitely a hedge as well. This is in addition to Puts people buy on the SPX and SPY also. While the VIX Calls are good for hedging, the way the VIX index works, its a bit difficult to find the exact amount of hedge required for a portfolio. Its a much simpler option to hedge with the SPX and SPY because you can calculate the amount of hedge very precisely.

      • The low VIX combined with cunerrt put/call ratio progressions seems a witches brew of complacency that can end quickly when the time comes. We won’t chase this top so much as take a few test shots to dial in the input paremeters to the algorithm. Want to keep reserves at the ready

    • Of late i dont trust the VIX a whole lot. Its not been moving.

  • By the way, I would be utmost interested by the vix calculation : I don’t remember if it’s sticky strike or sticky delta.

    • Yes, i will do a post on that. Its fairly complex because the VIX itself is not a traded security. So VIX Options key off the VIX Futures. Lets say the January Futures are at 20, and the VIX is at 14 today. If the VIX goes up to 16, normally you’d expect any Call option to increase in value. However, if the Futures don’t move from 20 to 22 (because futures players still feel 20 is the VIX forecast for January), then your calls will not increase in value. I’m just giving a simple example here, will cover it in a detailed post. Thanks for chiming in -

      • Where to now? It may become clear at some point, but at the moment it seems murky to me short term. Even now VIX levels are low.

      • Really dead today, volumes are weak. The SPX and INDU look to be prtiinng bearish evening star candlestick patterns if this holds into the close. I’m not holding any positions over the long weekend, but if I were I’d still be long. I’m not getting any sell signals right now. Another thought, if this is a quick B move up, then we could possibly see a pretty strong move to the downside soon. Still don’t like how smoothly the market corrected and bounced I would’ve liked to see more participation today with a wider range in price. Enjoy the weekend!

    • Hi, is this material applicable to indian stock markets ?

  • Very interesting post. Thanks. have you heard of the guys from tastytrade ? they are big on volatility plays