The VIX: No Longer Relevant

1:44 AM

Preface:  I have Msc in Finance and to say I even come close to understanding this is wrong. I only understand the basic concept. There are better experts out there.

Recently I have seen many in the community quote the VIX and how low it has become. They cite this as low volatility within the stock market or how a bubble has formed because we are at the low in the VIX.
Please do not be mistaken. I am also short SP500, but for different reasons.


Source: http://www.investopedia.com/articles/optioninvestor/03/091003.asp

And the VIX should not be one of them.'
I write this because it grinds my gears to hear people talk about the VIX like it is relevant.
So here we go:

************NERD WARNING************
If this is too nerdy, please skip to summary

The VIX uses the concept of implied volatility and assumes correct pricing. It then inputs them into the BSM Model. (Black-Scholes-Merton Option Pricing Model).

The BSM model has issues within itself, but for the sake of this discussion, let us assume the model is correct.

When prices differ between the out-of-the-money put and call options, the VIX will go up.
Quant funds use trading strategies such being short the VIX Futures and the SP Futures. Matching the tenor of course.

So if the SP500 increases, the VIX futures contract will offset the index futures. And vice versa for a drop.
This will allow one to mitigate the long-tailed risk of the SP500. But earn from the "carry trade" from the VIX futures due to the contango nature of future contracts. i.e. profits are from Theta being lower than contract price in the future.
This allows an almost risk-free bet.

And will happen until the arbitrage no longer exists, or risk appetite can no longer stomach it.
What strategies like this do is increase the demand for put/call contracts. And if there is an increase in demand, will prices increase. 

If so, prices increase. But why should "volatility index" change? Because we are using implied volatility, not actual volatility, it does.

************End Nerdiness************

Summary:

When the VIX was first introduced, it was a measure of volatility. But it has lost its place because of the introduction of sophisticated strategies.

The demand for these products is why we have the introduction of newer indices such as the VXST. 

I have two takeaways:
1) I do not have a good answer for an alternative gauge. Only that the VIX should no longer be one.
2) Market structure has changed. Because of the strategies that depend on contango, market movement in the market will be amplified.


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