It’s been ages since I spouted off on the CBOE Volatility Index (VIX), but after listening to the latest Trading Justice Podcast (Episode 281) and witnessing more than a few shots being fired its way, I thought a return volley was in order. I loved the conversation between Matt, Tim, and Keith and it’s worth a listen in full to get the entire context of the discussion. For brevity’s sake, I’m going to highlight a few comments and then provide my perspective.

“Tell me what the VIX represents and why traders should use it.”

The VIX is a measure of implied volatility using one-month SPX options. In other words, it reflects the expected movement of the market as implied by supply and demand for SPX options.

Usage #1: Frame Expectations

Traders can use it to adjust their expectations of how much daily movement the market should see. See my VIX Tricks article for reference. When the VIX is at 16, it tells me most days should see a move of 1% or less. That gives me a sense of how much volatility I will face and consequently, how much exposure I may want in my active trading account. When we see spikes in the VIX toward, say, 32, that tells me to prepare for 2% daily moves being the norm. In the 16 VIX environment, I may be comfortable with a beta weighted SPY delta of X. But when the VIX jumps to 32, I may only be satisfied with a beta weighted SPY delta of 0.5X since we’re seeing daily moves that are twice as big.

Usage #2: Identify Peak Fear

Many use the VIX as sentiment gauge, and due to its mean-reverting nature it’s much easier to spot actionable signals for when you should fade the fear by selling puts or put spreads on SPY or other related products. For example, see The Fear-O-Meter article.

Without the VIX or some equivalent metric (like IV Rank on SPY), it would be challenging to identify when it’s worth buying a market dip via SPY short puts. I’d rather sell bull puts on SPY when the VIX spikes above the upper bollinger band than sell bull puts when SPY goes down five days (or some other arbitrary number) and looks oversold.

Knowing that the spikes in the VIX toward significant levels like 30 or the high 40s are virtually always gifts for selling volatility or deploying bull trades in the market would have helped tremendously during the February crash. Anyone keeping an eye on VIX would have been more bold selling premium on the morning of Feb 6th when it looked like the world was ending.

The Epitome of Hyperbole

Next comment was a doozy.

“The VIX is completely and utterly useless, it is a useless indicator that doesn’t determine what to buy, what to sell. It is completely broken.”

Let’s start with the broken comment. I 100% agree with Tim’s rebuttal that this is like saying the temperature gauge is broken. The comparison is spot on. If it’s 95 degrees outside and the temperature gauge reflects as much, then it’s accurate. If there is little demand for SPX options due to a lack of volatility in the stock market and the VIX has been driven to ten, then it’s accurate. Now, you might contend that market participants are more complacent than they should be, but you can’t argue the VIX isn’t precise at a ten reading.

And as for the VIX maybe not being responsive enough (read: rising fast enough to show the type of fear we’ve seen in the past during a market sell-off), what the heck do you call the spike to 50 that we saw during the February crash? That’s as high as every other VIX spike seen in the past three decades save the 2008 episode alone which was the mother of all outliers. That includes the dot-com crash, the 2010 flash crash, the 2011 European sovereign debt crisis and the Aug 2015 market puke.

The VIX’s tendency to rise when fear enters the building still works just fine thank you very much.

Here’s another factor that will take your understanding of the VIX to another level. One of the best predictors of the VIX is near-term market volatility. In other words, how the market is moving RIGHT NOW has a big impact on how much participants believe it will move over the next month. It’s an example of recency bias. You can track the actual movement in the market using 10-day historical volatility (HV). As shown below the 10-day HV for SPY hasn’t been above 12% since mid-April and right now its nestled at 6.6%. How high do you think implied volatility should be in such a dead market? Would you pay a 15% volatility on an option when the stock has only been moving around 7% for three months?

Until the market starts moving more, you better believe implied volatility measures will remain subdued.

Like a millstone, low realized volatility hangs around the VIX’s neck.

Final thought. Matt did mention something like why not just use a break of support on the SPX as your signal for when to get bearish instead of obsessing over what the VIX is doing. On that note, we’re in complete agreement. But if you take that argument to extremes then why would we look at anything except prices charts? Why look at the news? Why look at economic reports? Who cares about the Fed, interest rates, inflation data, housing starts, employment information, and so forth?

Just let the charts be our guide!

I suspect some would answer: situational awareness. Because this data keeps us abreast of other trends or factors that may eventually impact the price chart.

The same is true regarding the VIX.

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