Many people associate the VIX with the word “fear” as Wall Street spends all day every day calling it the Fear Index. However, very few people do know the true purpose of the VIX and potentially how it can give us a reasonable gauge of how far the INDEXSP:.INX (S&P 500) might go.
Every time the market goes down, the talking heads on CNBC will rave about what the volatility index is doing on that day. They say that INDEXSP:.INX (S&P 500) trader are buying protection, fear is rising in the market, risk on, etc. While this is a great selling point for Wall Street and financial institutions, the VIX is not the Fear Index by any means and it is not more than a gauge of how far the INDEXSP:.INX (S&P 500) is expected to move over the next calendar year.
As with everything here at Stony Brook Securities, we do not buy into the status quo. We prefer to mute out all of the noise and figure out what is going on under the hood. Every year, analysts from the largest Wall Street institutions come out with their price targets for how far the index’s could go over the next year. While we think this is great and we wish all of those analysts the best of luck, we do not think spending all of those countless hours digging through thousands of balance sheets is worth it. Why might you ask? Because at all times, the collective market (the million of buyers and sellers) has an agreed on expected move for the INDEXSP:.INX (S&P 500) that comes in the form of a tradable assets. We will talk about what that asset is and exactly how you can find out the expected move for any timeframe for the S&P 500 in about 7 seconds.
What is the VIX?
We have already been down this road before. And thank you to the CBOE for explaining exactly how the VIX is calculated. While is it not important for us to remember or use at all when we are trading, sometimes it’s fun to hear how some of these metrics are calculated.
Here goes my rant on the VIX…
What is the job of Wall Street?
Without getting into too much detail the goal of Wall Street is two-fold:
- Gather assets
- Charge fees
That’s it. That’s the name of the game. Collect and manage as much money as possible so that the manager of the funds make more money by charging fees on a large pool of money. Simple enough.
Ever wonder why every single one of these”low-cost mutual funds” offers a “free” way to continue to reinvest your dividends and profits? Yep, you guessed it. It is more money for them to charge fees on.
So Wall Street came up with this nice marketing play to scare everyone into handing over their money to the money managers…where they could…charge fees. That marketing play was the sale of fear. The VIX is one way they do this. But enough about marketing, we are here to make money, and the volatility index known as the VIX is an excellent tool to help us do that. On wit it!
How Can the VIX Help us Figure out How Far INDEXSP:.INX Might Go?
Take a look at this interactive chart below. Just 10 cells in a Google sheet can really hold some incredible data. Here we see in the first column the price of the S&P. The second column is the one day expected move in the S&P, the third column being the 30 day expected move, the fourth column being the 90 day expected move, and the last column being the one year expected move.
You might be asking, “where are you getting those numbers from?”. The truth is, we only need two numbers that have been sitting their right under your nose all along 🙂
This data actually gets updated every few seconds so if you happen to be reading this article during the live trading day you should refresh this page every so often so we can see these numbers change in real time. Markets move and so do the expectations of price movement.
But how are we coming up with these numbers exactly?
Drum roll please…
We are using the VIX!
The VIX…ladies and gentlemen, is nothing more than the expected move up or down in the INDEXSP:.INX (S&P 500) over the next year.
Mind blown? Let’s see if I actually know what I’m talking about…
S&P 500 Expected Move Calculation
The interactive widget above uses a quick and easy equation to find the expected move in the S&P 500 for ANY timeframe. You will be surprised as it is quite simple. Let’s walk through it.
We have the current price of the SPX which right now is $2,373.47. Boom.
We have the current price of the VIX which is $11.35. Boom.
That is it. Those are the “surprise” two data points that we need. I told you they were sitting right there in front of you all along.
Again, why do we care about the VIX here? I thought it was the scary Fear Index? No…it’s not. It is just the expected move over the course of the next year in the S&P 500. And if we know what the expected move up or down is in the next year, we can easily break that down or out to any timeframe we want!
All we need to do is the following:
S&P 500 Price * (VIX price/100) * sqrt(days/365)
The current VIX and S&P prices are fluctuating all day every day (so is our interactive widget) so the following examples will be accurate for the given prices. Let’s do some examples so we can see what the expected moves would be in the INDEXSP:.INX with different S&P and VIX prices.
|S&P Price||VIX Price||Days||Expected Move||Equation|
For the first example above, the market believes the S&P will close between $2,468.06 and $2,278.88 in 45 days.
For the second example above, the market believes the S&P will close between $2,664.80 and $2,335.20 in 30 days.
For the final example above, the market believe the S&P will close between $2,303.95 and $1,964.05 in 90 days.
We did the same equation for all three examples above but just had different inputs for S&P price, VIX price, and days.
Where Do We Go From Here?
First of all…your welcome.
Let’s bring this back home and go over what we just spoke out. Remember, Stony Brook Securities does not buy into the hoopla that is Wall Street and financial media. The financial markets have a lot going on and there are trillions of dollars at stake. Our goal is to break things down into small ideas so that our students and clients can focus on the things that really matter throughout the course of every trading day.
For starters, the VIX is not the Fear Index. While it is calculated by running some crazy math on put prices from the INDEXSP:.INX (S&P 500), it is not a representation of fear.
However, it is a representation of the expected move in the S&P 500 over the next year. That’s it. Nothing more. When the VIX is higher, it is just telling us that the expected move in the INDEXSP:.INX (S&P 500) is larger.
Now…what are the two things we need to figure out the expected move in the world’s most popular index?
- Price of the S&P 500
- Price of the VIX
And then what do we do when we have them? We run our simple equation to figure out what is the expected move by inputting the amount of days out we are looking for.
S&P 500 Price * (VIX price/100) * sqrt(days/365)
And wallah! We can know with 100% confidence what the market believes is the expected move up or down in the S&P 500. No more guessing. Just pure numbers.