I promise you if you read this entire article…
It will open your eyes to something that you have never heard before…
And will likely never hear anywhere else.
The VIX, “The Fear Index”, is not what you think. Not by a long shot. But in order to get into why we need to get all of our cards out on the table.
Throughout this article, you will learn exactly how to use the VIX to your advantage to make more consistent and profitable decisions.
Below is your standard video of how the general public views the VIX. It is important you watch this before we can really get into debugging everything you have every heard about this volatility index.
Let’s Sum Up What We Think We Know…
- “The Fear Index” – The host in the video quickly off the bat jumps right in to use the buzz word “The Fear Index” when describing the VIX. He is making the argument that the higher the VIX, the more “fear” there is out there. This is something that you have heard before…guaranteed.
- The VIX is priced off the number of puts bought in the SPX – The more put buyers there are, the more “fear” there is out there…thus the more puts bought the higher the VIX.
- When puts are high, that means people are buying protection – Very similar to the above bullet points. If the premium in the puts are higher (puts are high) people are protecting themselves from downside movement in the market.
- When VIX goes up price goes down – As equity prices rise, volatility decreases. When equity prices decline, volatility increases.
You know all of this. You have heard all of this before. The VIX is “The Fear Index”. When the VIX is going higher it is because we are selling off and people are trying to “hedge” their portfolio.
What Actually is The VIX?
“The Fear Index…?”
Is the VIX “The Fear Index”? I guess? But only because Wall Street gave it that name. And there is no confusion about why they came up with a name like that…
See the goal of Wall Street is to:
- Overcomplicate everything
- Scare you
They do these two things so that you feel like you cannot manage your own money. And if you don’t manage your own money who is going to?
And what happens when they manage your money?
They get paid!
So yes, the whole concept of “The Fear Index” is just another tool to make sure you hand over your money to Wall Street so that they can charge you fees.
That makes sense…but if it’s not “The Fear Index” then what is it.
Drum roll, please…
The VIX is the daily expected move in the S&P 500
Fear only comes when things are unknown…
That is why in your eyes, the VIX will never again be “The Fear Index” because you now know the VIX is just a representation of what the market expects the daily expected move in the S&P 500 to be.
How can it be scary now that you know with 100% confidence what the market thinks is going to happen?
Want to hear something that you will not hear anywhere else?
A 19 VIX represents an expected daily move in the S&P 500 of 1%
There you go…
The VIX is no longer “The Fear Index” to you…
It is the daily expected move in the S&P 500.
A 19 VIX represents an expected move of 1% in the S&P 500 up or down.
A 38 VIX represents an expected move of 2% in the S&P 500 up or down.
And so on…
I know that just blew you away, but as mind blowing as this seems, we are just getting started!
The VIX is Priced Off the Number of Put Contracts Bought in the SPX?
Sorry…I have to take a little bit of a detour here…but just for about a minute or so.
The notion of the VIX being priced off puts being bought is ridiculous to me…
Well for starters, just like in any other trade in the world for every buyer there must be a seller. Rather than saying the VIX is high because people are buying puts/protection, why can’t we just be realistic and say the VIX is higher because more put contracts have traded further out of the money?
Now that we got that out of the way, let’s get back into focus.
I am going to apologize ahead of time for what I am about to say…
The VIX is kinda a completely arbitrary number. Why might you ask? Because the VIX isn’t really priced off of put buying and selling…
Let’s dig in.
If you are not an options experts, have no fear! All you need to know for this next section is that the At The Money options strike typically come with a 50 delta.
Let’s look at some examples:
Facebook closed the day yesterday at $124.96, making the At The Money strike the $125 strike. Both the calls and the puts have a 50 delta here.
Apple closed the day yesterday at $106.94, making the At The Money strike the $107 strike. Both the calls and the puts have a 50 delta here as well.
IWM (Russel 2000 ETF) closed the day yesterday at $123.06, making the At The Money strike the $123 strike. Both the calls and the puts have a 50 delta here too.
VIX closed the day yesterday at $13.65, making the At The Money strike the $13.50 strike. Both the calls and the puts DO NOT have close to 50 deltas here…
Ummmmmmmmmmm? Why is the At The Money strike full of 50 deltas for everything else except the VIX? That doesn’t make any sense!
Have you ever heard of the VIX futures?
They are nothing more than a volatility futures contract…similar to the way the S&P 500 has futures contracts.
But who cares! We aren’t futures traders!
Well, you should care…
We just saw that the VIX’s At The Money options are priced differently than any other stock out there…but why is this the case?
Remember before when the VIX was at $13.65 and the $13.50 strike did not have 50 delta options?
Remember when the closest thing to 50 delta options in the VIX was the $15 strike?
Would it be strange if something that you never heard of before, namely the VIX futures, closed the day at $15.125?
Could this be the reason the VIX options are “not normal”?
You bet your butt they are!
The VIX is a Completely Arbitrary Number…
Different than other stocks, the VIX is a cash-settled index. A cash-settled index is something that does not trade in shares, you cannot buy or sell shares rather you can only trade options. Where if you have an in the money option at expiration on all non-cash settled indexed, you are given shares.
To sum that up, in a cash settled index like the VIX, everything settles to cash rather than stock.
Let me explain why the VIX is arbitrary…
The VIX is just an arbitrary number because it comes to parity with the VIX futures on it’s exportation day.
Yes…it’s just an arbitrary number.
And if it’s goal is to come to parity with something else, then shouldn’t we be concerned with only what is comes to parity with?
In our example above, while the VIX is trading at $13.65, the real at the money strike is the $15 strike because the VIX future expiration cycle it is trading off is at $15.125.
So all along we kinda just have this arbitrary number that is out there. People will be saying it is based off put buying when really is it just a number who’s sole purpose is to come to parity with what it really trades off of…the VIX futures.
What we just learned
That was a lot I know. But it was important for us to have that talk.
I am happy that you now know the following:
- The VIX is not “The Fear Index”, rather is it just the expected daily move in the S&P 500.
- The VIX is a completely arbitrary number because it’s purpose it to be a cash settled index that comes to parity with the VIX futures when they expire.
How Does This Help You?
Well for starters, now you have a reasonable expectation of daily market movements. 99.99% of traders and investors out there have no clue about this.
Imagine you wake up one morning and see the VIX at $19.
You go to yourself, okay, I know that represents a 1% expected move for today…
Right now with the SPX at $2169.04. That would mean roughly a $21 expected move if you assume a $19 VIX.
You trade the open in the morning.
Go out for a nice lunch at the local diner.
Come back, open up your platform and see the SPX is up $20.
You hear everyone talking on CNBC about buying because we are about to take off.
You listen to you trader friends tell you there is going to be a breakout.
But you say to yourself…”How much more can we go? There is a $21 expected move today and we are already up $20…”
And instead of buying when everything is already up at the expected move, you sell into the strength because you have reasonable expectation on price movement because you are basing your decisions on what the market thinks!
You my friend, have officially become a trader.