Can volatility predict market crashes?

published 8 June 2006

Volatility indices are widely used as barometers of sentiment, and are supposed to tell us whether markets will be rocky or stable in the future. Do they work?

What is the VIX?

It may sound like a cold remedy or a cleaning product, but the VIX is actually the Chicago Board Options Exchange (CBOE) Volatility Index. Often called the investors' fear gauge, the VIX is widely used as a barometer of market sentiment. Essentially, it's supposed to measure the markets' expectation of how much share prices will move over the next 30 days. A rapid increase suggests that investors are pricing in sharp moves, while a drop indicates more stability is expected.

How is it calculated?

Through some fiendishly complicated mathematics. The CBOE calculates the VIX from a weighted basket of options on the S&P 500 index. These include both at-the-money options (those where the strike price the price at which the option can be executed is the same as the current price of the underlying security) and away-from-the-money options (where the strike price is not equal to the current price). The contracts used are usually the nearest and second-nearest to expiry. The intention is to estimate the volatility of a theoretical at-the-money option on the S&P 500 index with 30 days left to expiration. Formula junkies can find the entire process explained at www.cboe.com/micro/vix.

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How do you translate the result?

The VIX is quoted as a percentage and equates roughly to the expected movement in the S&P 500 index over the next 30 days, given on an annualised basis. For example, a VIX of 24 means that the options market expects the S&P 500 to move up or down by 2412=6.93% over the next month.

Why is the VIX useful?

Many investors see it as a tool for forecasting future market conditions. Since options are a form of insurance against market movements, option prices tend to rise during times of financial strife and falling markets, and slump when all seems well. As a result, the VIX generally moves inversely to stockmarkets, rising when stocks fall and vice versa. This isn't always the case it was often high during the last stages of the dotcom bubble because even though the market was rising overall, daily movements were quite volatile but usually the relationship holds up well. A VIX under 25 is seen as a sign that markets will continue to be stable, while a higher one is taken as an omen of trouble on the way. But some contrarians see extreme VIX levels in a different way.

What do the contrarians say?

That a really low VIX (less than 20) is a very bearish indicator as it suggests that investors are too complacent. Many are gloating over the recent market turmoil, as it comes after a long period of extremely low VIX numbers. High readings (30 or more) are seen as bullish, as it points to investors being overwhelmed with fear, creating opportunities for those that keep their heads. For example, the graph shows sharp spikes during both Gulf Wars, September 11, the Asian and Russian crises, and the collapse of hedge fund Long-Term Capital Management. Most of these panics subsided reasonably quickly.

What are the criticisms of the VIX?

Some say that it can be misleading to use the VIX as a barometer of sentiment for equity markets as a whole. The VIX is based on options on the S&P 500 index, but the volatility of index options sometimes varies from the volatility of individual equity options. Volatility can also vary within individual market sectors, so using one figure to represent all equity volatility may be simplistic. In addition, the VIX is based on a 30-day option, but longer-dated options are generally more popular for equities.

Is the VIX the only volatility indicator?

No. The CBOE also calculates the VXN (Nasdaq volatility) and the VXD (Dow Jones volatility), but neither are as widely studied as the VIX. Other exchanges also provide similar indices, such as the American Stock Exchange's (AMEX) QQV, which measures the volatility of options on its Nasdaq-tracking stock, QQQ. Eurex recently launched volatility indices for the Eurozone Stoxx 50, German Dax and Swiss SMI. But the VIX remains the most widely used measure of volatility.

Are these indices good for more than forecasting?

Yes. Investors are increasingly looking for ways to hedge the volatility risk, so the AMEX, the CBOE and Eurex offer futures and options contracts on their volatility indices. Spreadbetters such as City Index and IG Index also offer spreads on the VIX to retail investors. However, institutional traders still prefer over-the-counter volatility and variance derivatives, which give them more flexibility for example, they can run over longer periods than the VIX's 30 days and on more markets. Variance swaps, which are calculated on the square of volatility, also offer much higher leverage, meaning much greater potential gains but potentially unlimited losses as well.

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.