The Volatility Index: Reading Market Sentiment

Known ominously among investors as the "fear index" and launched by the Chicago Board Options Exchange (now the Cboe) in 1993, the Volatility Index (VIX) is meant to present the market's expectation of volatility over the coming 30 days. The metric is derived from options prices on the S&P 500 Index and captures the anticipated swings that drive investor sentiment.

In recent years, the VIX has become a far more central index, especially during periods of financial turbulence, such as the 2008 financial crisis and the COVID-19 pandemic. During these stretches, spikes in the VIX reflected widespread anxiety; during others, it's been a crucial barometer for market participants seeking a glimpse into investors' collective psyche. When the VIX is low, this suggests calm seas ahead. When it spikes, it signals approaching storms.

Below, we explore how the VIX is used as a contrary market indicator, how it measures institutional sentiment, and why an understanding of the VIX tends to favor specific strategies over others.

Measuring Market Movers

Investors have attempted to measure and follow large market players and institutions in the equity markets for over 100 years. Following the flow of funds from these giant pipelines can be essential to investing success.

Traditionally, smaller investors want to see where institutions are accumulating or distributing shares and try to use their smaller size 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's important to remember that these large market movers are like ocean liners—they need plenty of time and make waves when they change direction; you don't want to be a small boat capsized when it does.

Institutions can't quickly unload the stock when the market is turning bearish. 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 measures supply and demand for options and a put/call ratio. An option contract can signal intrinsic and extrinsic value:

• Intrinsic value is how much stock equity contributes to the option premium.
• Extrinsic value is the money paid over the stock equity's price.

Extrinsic value consists of the time value, the premium paid until expiration, and implied volatility (IV), which is how much (more or less) an option premium swells or shrinks, depending on the supply and demand for options.

Since the VIX is the IV of S&P 500 Index options, these options have such high strike prices, and the premiums are so expensive that very few retail investors are willing to use them. Usually, retail option investors will opt for a less costly substitute like an option on the SPDR S&P 500 ETF Trust (SPY), an exchange-traded fund that tracks the S&P 500 Index. If institutions are bearish, they will likely buy puts as a form of portfolio insurance.

The VIX rises because of increased demand for puts but also swells because the demand for put options increases, which will cause the IV to rise. The price increases because demand drastically outpaces supply.

VIX Strategies

A mantra investors learn early on is, "When the VIX is high, it's time to buy. When the VIX is low, look out below!" As an example, the figure below identifies various support and resistance areas from earlier in the history of the VIX. Notice how the VIX established a support area near the 19-point level early on and returned to it in previous years. Support and resistance areas have formed over time, even in the trending market from 2003 to 2005.

During this period, when the VIX reached the resistance level, it was considered high and was a signal to purchase stocks—particularly those that reflect the S&P 500. Support bounces indicate market tops and warned of a potential downturn in the S&P 500.

Perhaps the most important thing to glean from the above is how elastic IV is. 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 is helpful—just as the VIX's contrary nature can help options investors make better decisions. Even after the extreme bearishness of 2008 to 2009, the VIX moved back to that normal range.

Optimizing Options

"If the VIX is high, it's time to buy" tells us that market participants are too bearish and IV 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 does the option price, while negative vega translates into a position that benefits from a decrease in the IV.

"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's rare, there are times when the normal relationship between VIX and S&P 500 changes or "decouple." The chart below is 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 retail investors, 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 taken as a warning that the market trend will soon reverse.

The Bottom Line

VIX measures the market's expectation of volatility over the next 30 days based on S&P 500 index options. A higher VIX value indicates greater anticipated volatility and market uncertainty, while a lower VIX value suggests market stability. Key levels and trends in the VIX can inform trading strategies.

It's a contrarian indicator that helps investors look for tops, bottoms, and lulls in the trend. It allows traders to get an idea of large market players' sentiments, which is helpful when preparing for trend changes and determining which option hedging strategy is best for their portfolio.