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Article by dailystock_admin    (05-05-09 12:16 PM)

What is the Volatility Index or VIX?

Volatility index or VIX, captures the "fear index", which indicates the indicates the fear in capital markets at any point of time and helps investors understand market risks in a better manner to take sane decisions accordingly. The Chicago Board Options Exchange (CBOE) was the first to develop volatility index in 1993. Since then, the ‘risk index’ VXN, which tracks the Nasdaq and VXD, that tracks the Dow Jones Industrial Average have also been introduced in US markets.

The implied volatility, as captured by the volatility index, is not about the size of the price swings, but rather the implied risks associated with the stock markets. Implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the belief that bearish markets are more risky than bullish markets. In effect, the Volatility Index (VIX) is a contrarian sentiment indicator that helps to determine when there is too much optimism or fear in the market. When sentiment reaches one extreme or the other, the market typically reverses its course.
Market volatility keeps changing as new information flows into the market. High readings indicate a higher risk in the market place. Higher the implied volatility, the VIX value also goes up higher and vice versa. A high value of VIX corresponds to a more volatile market and therefore more costly options, which can be used to defray risk from volatility. If investors see high risks of a change in prices, they require a greater premium to insure against such a change by selling options.

A key way to analyze the volatility index is to put a Bollinger band around it. When the Volatility Index goes outside the upper Bollinger band, the market is overly complacent. When it goes below the lower Bollinger band, the market is overly anxious. A pullback within the band is a sign that the market is turning.

The VIX theory was first introduced in a paper by Professor E. Whaley of Duke University in 1993. Robert E. Whaley is a renowned expert in the field of derivative securities, including contract valuation and risk management, market microstructure and market volatility. His distinguished teaching career, numerous articles, and many books have brought him national and international recognition in both the business and academic worlds. Among his many industry innovations are the development of the Market Volatility Index (VIX), the NASDAQ Market Volatility Index (VXN) and the Buy Write Monthly Index (BXM) for the Chicago Board Options Exchange. He has also held faculty positions in different universities and also served as a consultant to investment houses worldwide.
At times, the relationship of the VIX to individual equity options can be easily overstated. It often appears that different dynamics drive the volatility of index options compared to that of equity options, and the two can often be uncorrelated. In particular, the VIX is limited to a 30-day period, while for most non-index equity options, the most liquidity is usually found in the 2 to 6-month maturities. In addition, volatility is often a function of market sector. For instance, volatility is usually assumed to be high in technology stocks, and low in utility stocks. Using a single number such as the VIX is not advisable in such cases.
References:
• Keith Black. (2005) “How the VIX Ate My Kurtosis." Presentation.
• Matthew T Moran, (2004) "Review of the VIX Index and VIX Futures." Journal of Indexes. October 2004.

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