The CBOE Volatility Index, or VIX, is a real-time market index representing the market's expectations for volatility over the coming 30 days. Investors use the VIX to measure the level of risk. The answer to this question can explain also why markets fall harder than they rise. It is true, that theoretically as a market swings upward quickly, one can argue that the VIX should rise as traders rush to call options to hedge their short posi.
It generally happens right before periods of uncertainty. Leading up to Brexit it happened on some days. Leading up to election. Sometimes leading to a FED meeting. In this case perhaps it has to do with the tax bill.The market has climbed a lot the past few days, meaning the market is a bit stretched in the short term.
Therefore, VIX climbs in anticipation that we can't go much higher and that some selling will happen soon.Does it sometimes lead to increased realized volatility/sell off? Other times the VIX increase simply dissipates over a few days while the market stays flat or drops a fraction of a percent. More.The VIX is a measure of basically.unexpected craziness in the market.When the market generally moves unexpectedly in a direction rather violently or suddenly.the VIX will spike up.Follow or watch this on a daily time scale, in relation to the SPY. You'll kind of grasp a sense of it.I like to think of it as more of a Complacency or group-think measure. It could also be used as a 'harbinger' tool as well.You need a dynamic, variable mind to succeed in the market and trading. Nothing is black or white or etched in stone.To build a house you need tools and fixed plan; with the market.you need a collection of tools and considerations, and no fixed plan.
It appears that the log 'returns' of the VIX index have a (negative) correlation to the log 'returns' of e.g. The S&P 500 index. The r-squared is on the order of 0.7. I thought VIX was supposed to be a measure of volatility, both up and down.
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However, it appears to spike up when the market spikes down, and has a fairly strong negative correlation to the market (in fact, the correlation is much stronger than e.g. For your garden variety tech stock).Can anyone explain why? The mean 'returns' of both indices are accounted for in this correlation, so this is not a result of the expectation of the market to increase at 7% p.a.Is there a more pure volatility index or instrument? Technically, yes, the VIX is a measure of implied volatility. But practically speaking, it is a measure of market uncertainty: when market participants are uncertain of the future, they buy options to protect their positions, driving up option premiums and increasing implied volatility.The broader market hates uncertainty, however, so that same uncertainty drives some participants to sell off their holdings or, at least, stop buying.
That drives down market prices, creating a correlation between rising implied volatility and falling prices.If you want a 'more pure' volatility index, perhaps could be useful to you. That is a backward-looking measure, of course, but any forward-looking measure will inevitably be tainted by people's emotions and, hence, less pure. VIX is from the price of S&P500 call and put options.
So if the demands for S&P500 calls/puts rise, then the prices rise, then the implied vol from these options rises. During a down market there's a lot of demand for portfolio protection. If you're diversified, then S&P500 puts are good protection, so the prices for puts rise and the implied vol from puts rises.
The vol rise from puts drives the VIX up. In most cases the implied vol from calls probably contributes, too, but it's the puts driving VIX. There is no theoretical reason why any volatility index should be directionally correlated to its underlying asset. However, the VIX is indeed negatively correlated to the S&P. And if you look across FX markets, you will find similar, including opposite (ie price up = vol up), effects priced into their risk-reversal curves.Theory in the sense of the Black-Scholes framework assumes a default lognormal return distribution. If any market exhibits significantly skewed and kurtic returns in reality, then the probability of a major decline, slight decline, slight appreciation and major apprecation will not be in balance.
A decline or an appreciation will then be more or less likely to be either slight or major in scale.This produces the vol-smile seen in these markets. And when spot moves, measures like the VIX will shift to give a greater or lesser weight to different strikes along the curve, which have different associated volatilities. S&P down moves the move to weight lower stikes, that have higher vols, more heavily. And vice versa.Short answer: vol-spot correlation is a function of skew and kurtosis in the return distribution of the underlying market that the vol series is tracking.