April 07, 2009 at 6:00 am by Tom Lydon
Volatility has been measured for the past 20 years by the VIX, and it goes up when stocks and exchange traded funds (ETFs) drop and vice versa.
So the million dollar question is why does the VIX move in the opposite direction of the markets? The answer is options. Generally, when the market tumbles, speculators, hedgers and investors buy options for several different reasons. As more buyers come into the market, there is upward pressure on option prices, states Mark Wolfinger of Minyanville. The VIX generally increases during these times.
The opposite is also true. When the markets are rallying and gaining ground, there is no urgency to hedge and panic is absent, therefore bringing the trading volume in calls down. This doesn’t mean that no one is buying calls, some are, but most are selling options, sending the VIX down.
These are general rules and lately we have seen from divergence from the norm. There have been bullish periods were the VIX increased and bearish periods were the VIX decreased. As for right now, the VIX is around 43, which means that there is a 68% chance that the realized market volatility will be less than 43 and a 32% chance it will be higher than 43 30 days from now.
The aforementioned is exactly what the VIX is supposed to represent: An estimate of future volatility in the options market. Only time will tell if it more than just a measure of volatility and is a measure of fear in investors, as well.
Kevin Grewal contributed to this article.
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