VIX

Imagine you're about to go on a roller coaster. Some days, the ride looks pretty calm — small ups and downs. But other days, you can tell it's going to be wild with huge drops and sharp turns!

The VIX is like a sign at the roller coaster entrance that tells you how wild the ride might be today. When the sign shows a high number, people think the ride (the stock market) is going to be really bumpy and scary. When it shows a low number, people think it'll be pretty smooth.

The cool thing is: the VIX doesn't tell you if the roller coaster goes up or down — just how shaky the ride will feel!

Historical context: The VIX was created by the Chicago Board Options Exchange (CBOE) in 1993. Before this, there was no standard way to measure market fear. Professor Robert Whaley designed the original formula, and it was revolutionary — for the first time, investors could see "fear" as a number.

The original VIX tracked S&P 100 options. In 2003, CBOE updated it to use S&P 500 options, which better represents the broader market. They also changed the math to make it more robust.

Key historical moments:

• Normal times: VIX hovers between 12-20
• 2008 Financial Crisis: VIX hit 80 — absolute panic
• March 2020 (COVID crash): VIX spiked to 82, the highest ever recorded
• Calm markets (2017): VIX averaged around 11, unusually low

Why "Fear Index"? When people are scared, they buy insurance for their stocks (called "put options"). More demand for insurance = higher prices = higher VIX. It's measuring the cost of fear.

What VIX actually measures:

VIX is the implied volatility of S&P 500 index options, expressed as an annualized percentage. It's calculated from the prices of SPX options expiring in approximately 30 days.

The key insight: Option prices contain embedded expectations about future volatility. If traders expect big price swings, they pay more for options. The VIX reverse-engineers this expectation from observed option prices.

Important characteristics:

• Mean-reverting: VIX tends to return to its long-term average (~20). Extreme highs don't last forever
• Asymmetric: VIX spikes quickly but declines slowly. Fear arrives fast; calm returns gradually
• Negatively correlated with S&P 500: When stocks crash, VIX jumps (correlation around -0.7)
• Futures term structure: Usually in "contango" (future VIX > spot VIX), reflecting risk premium

Trading the VIX:

You can't buy VIX directly (it's just a number). Instead, traders use:

• VIX futures: Contracts that settle to VIX value at expiration
• VIX options: Options on VIX futures
• VIX ETFs/ETNs: Products like VXX (short-term) or UVXY (leveraged) that track VIX futures

VIX calculation methodology:

The modern VIX (post-2003) uses a model-free approach based on a replicating portfolio of out-of-the-money (OTM) puts and calls. The formula:

Where: T = time to expiration, K = strike prices, Q(K) = midpoint of bid-ask for each option, F = forward index level, r = risk-free rate.

Why this formula? It's derived from the variance swap rate. The sum over strikes approximates the cost of replicating a variance swap using vanilla options. This is "model-free" because it doesn't assume Black-Scholes or any specific distribution.

Volatility risk premium:

Historically, implied volatility (VIX) exceeds realized volatility by 2-4 points on average. This "volatility risk premium" exists because:

• Investors are willing to overpay for downside protection
• Volatility has negative correlation with returns (it's a hedge)
• Selling volatility is risky — occasional blowups (short gamma)

VIX term structure and trading signals:

• Contango (normal): Far VIX futures > near futures. Market expects calm now, risk later
• Backwardation (crisis): Near futures > far futures. Panic now, normalization expected
• VIX/VIX3M ratio: When short-term VIX exceeds 3-month VIX, fear is acute — often a contrarian buy signal

VIX as a tradeable asset — structural issues:

The VIX futures market has peculiar dynamics. Spot VIX is not directly tradeable; futures converge to spot at expiration. This creates:

• Convexity effects: VIX futures have negative convexity to spot — they underperform in both spikes and declines relative to a delta-hedged position
• Roll yield: Dominates long-term VIX product returns more than spot VIX movements
• Variance swap vs. VIX: VIX approximates the variance swap rate, but replication is imperfect due to discrete strikes and truncation at high/low strikes

VVIX — volatility of volatility:

CBOE publishes VVIX, the implied volatility of VIX options. VVIX typically ranges 80-140. High VVIX indicates uncertainty about the direction of volatility itself — often preceding regime changes.

Volatility surface and skew:

VIX is an aggregate measure; the full information is in the volatility surface. SPX options exhibit steep negative skew — OTM puts are much more expensive than OTM calls. This skew itself is tradeable and mean-reverting.

VIX clustering and regime models:

Volatility exhibits clustering (GARCH effects) and regime-switching behavior. Low-vol regimes can persist for years, then abruptly shift to high-vol regimes. Markov-switching models capture this better than continuous models.

VIX manipulation concerns:

The VIX settlement auction (every Wednesday) uses SPX option prices in a specific window. Research suggests potential manipulation around settlement — wide bid-ask spreads in illiquid deep OTM options can be exploited. CBOE has implemented reforms, but the issue persists.