Decoding the VIX: A Sentiment Gauge Beyond Technical Analysis

Technical analysis is a way to look at price action through the lens of charts, trends, patterns, and even sometimes indicators. However, when it comes to the VIX, the famed “Fear Gauge,” traditional charting and technical analysis may not be as insightful as you’d hope. Attempting to chart the VIX is a less fruitful effort and it’s far superior to be used as a sentiment gauge, for fear and market volatility. To grasp this concept fully, let’s delve into the intricacies of the VIX, its calculation, mean-reverting nature, and its intriguing partners, the CBOE VVIX and Skew Index.

Understanding the VIX and Its Calculation

The Chicago Board Options Exchange (CBOE) Volatility Index, widely known as the VIX, is a measure of market expectations for future volatility, often referred to as the “fear gauge.” It represents the market’s consensus of expected price swings over the next 30 days, derived from S&P 500 index options. The VIX is calculated based on the premiums of these options and provides a numeric value, often oscillating inversely to the S&P 500 index.

The first step in VIX calculation is identifying which options contribute to the index. To ensure a representative sample of market expectations, options must meet specific criteria. They should have a minimum remaining time to expiration (typically over 23 days and up to 37 days), and both call and put options are considered. Notably, only options with non-zero bid prices are included, ensuring the exclusion of illiquid contracts.

The VIX then quantifies the implied volatility of these options. Implied volatility is the expected future volatility derived from the option’s price, as opposed to historical volatility, which is based on past price movements. The VIX calculation looks at both call and put options, emphasizing at-the-money and near-the-money options, where investor expectations tend to concentrate.

Once the implied volatilities are obtained for the chosen options, the VIX formula averages them with a twist. Instead of a simple arithmetic mean, the VIX uses a weighted average to ensure that different options contribute proportionally to their liquidity. More actively traded options have a more significant influence on the final VIX figure. This weighting mechanism aims to provide an unbiased reflection of market expectations.

The final VIX value is an annualized representation of this implied volatility, as a percentage. For instance, a VIX value of 20 implies that the market expects an annualized future volatility of 20%, roughly 1.25% within the upcoming 30 days.

The VIX’s Mean-Reverting Nature

One of the most compelling aspects of the VIX, which makes it an indispensable tool for traders and investors, is its mean-reverting nature. This property allows the VIX to be used effectively as an oscillator. Instead of thinking of the VIX as an instrument that can be charted like normal price action, strictly horizontal levels should be used.

The VIX typically oscillates between low and high values. Historically, the VIX’s long-term average hovers around 19. However, in practice, it often exhibits a form of oscillation within a more nuanced range for select periods of time. When stock market volatility is low, the VIX tends to register at the lower end of the spectrum. Conversely, when market uncertainty and fear rise, the VIX spikes to higher levels.

For example, in the preceding years, the VIX saw a historically low range, often trading below 15, and clearly below the longer run average of 19. This period of subdued volatility was marked by consistent optimism and complacency in the market. As the stock market surged to new heights, market participants grew increasingly comfortable with the prevailing conditions.

In early 2020, as the COVID-19 pandemic shocked global markets, the VIX exhibited a sharp ascent, soaring above 80 at its peak. This extreme spike illustrated the fear and uncertainty that had gripped the financial world. A typical capitulation style read in the VIX is going to be far less extreme than this and get closer to the 40 handle. These conditions mark peak fear and uncertainty and can often be used as a contrarian indication that the market is approaching a near term bottom.

Beyond the VIX: CBOE VVIX and SKEW

To further complicate the matter, different derivatives of volatility also exist to help frame the context of any move in the VIX.

Just as the VIX measures volatility for equities, the VVIX (Volatility of the VIX) quantifies the volatility of the VIX itself. This index assesses how much the VIX is expected to fluctuate in the near term, reflecting market expectations of potential shifts in market sentiment. A rising VVIX implies increased uncertainty about future VIX levels, suggesting that traders expect more significant fluctuations in the VIX. On the other hand, a declining VVIX may indicate a more stable VIX and, consequently, a calmer market outlook.

The CBOE Skew Index, often referred to as simply the Skew, is an essential companion to the VIX. While the VIX gauges expected volatility in the near term, the Skew focuses on tail risk, specifically the risk of extreme outlier events. The Skew reflects the market’s anticipation of “black swan” events, where a significant and unexpected market crash could occur. When the Skew is elevated, it suggests that options traders are willing to pay higher premiums for out-of-the-money puts as insurance against catastrophic market events.

To put it simply, a high Skew implies a strong belief in the possibility of severe downside moves in the market, and, conversely, a low Skew indicates lower perceived tail risk. When used in conjunction with the VIX, the Skew provides a more comprehensive view of market sentiment, highlighting not only expected volatility but also the likelihood of extreme events.

Conclusion

Understanding volatility and market sentiment is paramount to understand the full context of the market. The VIX, VVIX, and CBOE Skew Index play distinct yet interconnected roles in unraveling the intricate web of market volatility. The VIX, as a gauge of short-term expected volatility, provides essential insights into near-term expectations and the VVIX a precursor to heightened VIX ranges. The CBOE Skew Index takes it a step further, revealing perceptions of extreme tail risk, helping traders prepare for “black swan” events. By incorporating these indices, traders can get a better picture for the trading environment that they are participating in.