The Volatility Index: Reading Market Sentiment

The Chicago Board of Options Exchange (CBOE) creates and tracks an index know as the Volatility Index (VIX), which is based on the implied volatility of S&P 500 Index options. This article will explore how the VIX is used as a contrary market indicator, how institutional sentiment can be measured by VIX, and why an understanding of the VIX tends to favor long and short puts.

Measuring Market Movers

Investors have been attempting to measure and follow large market players and institutions in the equity markets for more than 100 years. Following the flow of funds from these giant pipelines can be an essential element of investing success.

Traditionally, smaller investors look to see where institutions are accumulating or distributing shares and try to use their smaller scale to jump in front of the wake—monitoring the VIX isn't so much about institutions buying and selling shares but whether institutions are attempting to hedge their portfolios.

It is important to remember that these large market movers are like ocean liners—they need plenty of time and water to change direction. If institutions think the market is turning bearish, they can't quickly unload the stock. Instead, they buy put option contracts or sell call option contracts to offset some of the expected losses.

The VIX helps monitor these institutions because it acts as both a measure of supply and demand for options as well as a put/call ratio. An option contract can be made up of intrinsic and extrinsic value. Intrinsic value is how much stock equity contributes to the option premium, while extrinsic value is the amount of money paid over the stock equity's price. Extrinsic value consists of factors like time value, which is the amount of premium being paid until expiration, and implied volatility, which is how much more or less an option premium swells or shrinks, depending on the supply and demand for options.

As stated earlier, the VIX is the implied volatility of the S&P 500 Index options. These options use such high strike prices and the premiums are so expensive that very few retail investors are willing to use them. Normally, retail option investors will opt for a less expensive substitute like an option on the SPDR S&P 500 ETF Trust (SPY), which is an exchange-traded fund that tracks the S&P 500 Index. If institutions are bearish, they will likely purchase puts as a form of portfolio insurance.

The VIX rises as a result of increased demand for puts but also swells because the put options' demand increase will cause the implied volatility to rise. Like any time of scarcity for any product, the price will move higher because demand drastically outpaces supply.

Mantra Maxims

One of the earliest mantras investors one learns in relation to the VIX is "When the VIX is high, it's time to buy. When the VIX is low, look out below!" The figure below attempts to identify various support and resistance areas that have existed throughout the VIX's history, dating back to its creation in 1997. Notice how the VIX established a support area near the 19-point level early on in its existence and returned to it in previous years. Support and resistance areas have formed over time, even in the trending market of 2003–2005.

When the VIX reaches the resistance level, it is considered high and is a signal to purchase stocks—particularly those that reflect the S&P 500. Support bounces indicate market tops and warn of a potential downturn in the S&P 500.

Perhaps the most important tidbit to glean from Figure 1 is the elastic property of implied volatility. A quick analysis of the chart shows that the VIX bounces between a range of approximately 18-35 the majority of the time but has outliers as low as 10 and as high as 85. Generally speaking, the VIX eventually reverts to the mean. Understanding this trait is helpful—just as the VIX's contrary nature can help options investors make better decisions. Even after the extreme bearishness of 2008-2009, the VIX moved back within its normal range.

Optimizing Options

If we look at the aforementioned VIX mantra, in the context of option investing, we can see what options strategies are best suited for this understanding.

"If the VIX is high, it's time to buy" tells us that market participants are too bearish and implied volatility has reached capacity. This means the market will likely turn bullish and implied volatility will likely move back toward the mean. The optimal option strategy is to be delta positive and vega negative (i.e., short puts would be the best strategy). Delta positive simply means that as stock prices rise so too does the option price, while negative vega translates into a position that benefits from falling implied volatility.

"When the VIX is low, look out below!" tells us that the market is about to fall and that implied volatility is going to ramp up. When implied volatility is expected to rise, an optimal bearish options strategy is to be delta negative and vega positive (i.e., long puts would be the best strategy).

Derivatives During Decoupling

While it is rare, there are times when the normal relationship between VIX and S&P 500 change or "decouple." Figure 2 shows an example of the S&P 500 and VIX climbing at the same time. This is common when institutions are worried about the market being overbought, while other investors, particularly the retail public, are in a buying or selling frenzy. This "irrational exuberance" can have institutions hedging too early or at the wrong time. While institutions may be wrong, they aren't wrong for very long; therefore, a decoupling should be considered a warning that the market trend is setting up to reverse.

The Bottom Line

VIX is a contrarian indicator that not only helps investors look for tops, bottoms, and lulls in the trend but allows them to get an idea of large market players' sentiment. This is not only helpful when preparing for trend changes but also when investors are determining which option hedging strategy is best for their portfolio.