In the aftermath of the recent market correction, there is a lot of news about the VIX, popularly known as the market’s “fear gauge.” I update the VIX along with actual market volatility each week in my WTWA series. Let’s take a deeper look at this much-misunderstood indicator.

VIX Misconceptions

It is helpful to start by addressing the misconceptions.

• The VIX is a simple measure of anticipated market volatility. In itself, it is neither arcane nor dangerous.
• Many pundits turn it into some mysterious measure of market fear.
• Volatility is a measure of potential change in any direction (up or down) as well as overall fluctuations.
• People tend to use volatility as a euphemism for declines, but that is not strictly correct.
• Statistical analysis does not support the use of VIX as a predictor of market moves. More often it is a coincident indicator.
• The VIX has been around for about 25 years. By itself, it involves no more risk than trading, for example, a tech stock.
• Many ETFs and ETNs are derivatives of VIX, often putting a complex twist on a simple concept.

The Basic Facts

Historical volatility is a mathematical calculation based upon past data. Many people use the term without knowing how to do this calculation.

The value of options (equity and others) is based upon five factors identified by Fischer Black and Myron Scholes, who won the Nobel Prize in Economics for their work. (There have been some modifications in methods since then, but this is good enough for our current purposes). From Wikipedia:

One of the attractive features of the Black–Scholes model is that the parameters in the model other than the volatility (the time to maturity, the strike, the risk-free interest rate, and the current underlying price) are unequivocally observable. All other things being equal, an option’s theoretical value is a monotonic increasing function of implied volatility.

If there were no volatility – no expected change in prices – options would have no value – zero. If you take the trading price of an option and apply the four known factors, you can learn the level of volatility implied by the price. This usually has some relationship to the historical volatility, but sometimes does not. An impending earnings report, the results of a court case, or the outcome of a drug trial are all examples of situations where expected volatility would be much higher than historical values.

A higher expected volatility relates to a greater possible change in the underlying stock, either positive or negative. It could be fear, but it could also be greed.

What About the VIX?

The original idea behind VIX was to satisfy demand from professionals to hedge volatility exposure. Suppose, for example, that you were “long” volatility in many individual stocks, i.e., you owned options. You might sell the overall market volatility via the VIX to hedge your position.

The VIX is not an arbitrary value determined by some trading authority. It is calculated based upon a specified range, both in time and in distance from the underlying price of the S&P 500. Simply put, those trading the largest stock index, through their expectations, determine the implied volatility of the index options. Those options are then used to calculate the VIX. (CBOE). It is objective and mechanical.

Lessons for Individual Investors

Criteria often used by smart people would not have helped here. The track record of many dangerous products looked great. They were promoted by plenty of (self-proclaimed) experts. Instead of use as hedges against other positions in a portfolio, they became vehicles for speculation.

Pundit-in-Chief Cramer blamed a “group of complete morons” for blowing up the market (Shawn Langlois, MarketWatch). Shawn also describes the disasters in a Reddit group for XIV traders, including the story of a $4 million wipeout.

Many of these people were intelligent, not morons. Their actions were much like those of successful, risk-taking entrepreneurs who were confident of their business. The difference?

Something difficult and dangerous was made easy and tempting.

I recall a similar story from 1987. “Experts” of that era were peddling trading systems that involved selling naked puts. This worked well for years. It looked like free money, so people expanded their positions based on what they wanted to make rather than what they could afford to lose. These people were wiped out in the ’87 crash, positions sold to cover margin calls.

Ironically, ads for people selling these systems still ran in the next week’s issue of Barron’s. Apparently, the ads were already ordered and paid for!

After the crash, revised margin requirements and calculations for “tail risk” made it much more difficult to sell naked puts.

Regulatory Action – Time to Ban Some Products?

My friend and long-time colleague Scott Rothbort writes a regular column, My Gut Feeling, that is usually right on target. I find myself in partial disagreement with his advice about volatility products.

I hope that Scott can find time for a visit to Chicago. I’ll take him to the CBOE, to a great steakhouse, and to the racetrack with some of the local experts to enjoy his hobby. I hope he will see that the original CBOE product is fine and serves a purpose.

He and I should join forces in appealing to the SEC which approved the dangerous derivatives. Here is a list of about fifty of the volatility derivatives, all readily available for trading in your brokerage account. Beware!

The concept of volatility hedging is fine. Turning it into a tempting, overly-simplistic, one-click product was a big mistake.

Resources – Just a Few out of Many Good Ones

Lawrence G. McMillan, author of the authoritative work on options (and my required reading when I started in the business), has a good explanation of what happened, including some “inside baseball.”

Bill Luby’s blog, VIX and More, is loaded with authoritative content. You can also join me in following him on Twitter.

Adam Warner, columnist, blogger, and options expert, is another of my favorites on Twitter.