Measuring Investor Fearthe VIX

by Randy Frederick, Director of Trading and Derivatives, Schwab Center for Financial Research
March 11, 2009

Often referred to as the investor fear index, the VIX is a measure of the markets
expectation of volatility over the next 30 days.

The VIX can help you take a position on market volatility, typically with lower costs than
those associated with multi-leg options strategies.

The VIX also can be used to help establish a partial hedge against sharp market moves.

Its a widely held belief that the market is driven by two things: fear and greed. If thats true, then
having a way to help gauge one of these emotionsfearcould be beneficial. The Chicago
Board Options Exchange (CBOE) Volatility Index (VIX), often referred to as the investor
fear index, is a popular measure of the markets expectation of volatility over the next 30-day
period. It is calculated using the implied volatility of S&P 500 Index options (SPX). A spike in
the VIX often corresponds to a more volatile market because investors who see a high risk of a
change in prices will usually be required to pay a greater premium.
In this article, well look at how you may be able to use the VIX to take a position on volatility,
and as a hedge against sharp market moves.
What makes the VIX different?
Its important to realize just how different options on the VIX are from other options. Since the
VIX is an index of implied volatility, a VIX option is an option on implied volatilitynot on a
stock, ETF or stock index. If youve ever traded options, you probably know that the price of an
option is partially based on the implied volatility of the underlying instrument. In this case, that
underlying instrument would be implied volatility. If thats true, then the implied volatility of
VIX options is the implied volatility of implied volatility, which would be the second derivative
of the price of the SPX. Unless you are a brilliant mathematician, just thinking about this can
give you a headache. Since spikes in volatility tend to be relatively larger than the market
movements that cause them, the volatility of volatility is quite extreme. As a result, the implied
volatility component used in the calculation price of VIX options may make them appear
significantly more or less expensive than traditional options. Note: You can find quotes for the
VIX by visiting Schwab.com and entering the symbol $VIX.
Volatility skyrockets
It might surprise you to learn that prior to the tremendous volatility spikes in October and

November 2008, volatility as measured by the VIX had been at historically low levels for over
five years (with the exception of a few very small spikes in August 2007, January 2008 and
March 2008). In contrast, spikes like these in October and November are precisely why the
actual (long-term historical) volatility of the VIX is quite high, especially over the past 1015
years (the VIX was introduced in 1993). While the chart below only shows the recent spikes in
2008, prior to September 2008, the VIX (represented by the candlestick chart) hadnt been above
38% (represented by a red line) since March 2003. However, at the peak of the October spike it
exceeded 89% (represented by a green line). Its interesting to note that from mid-2003 until
mid-2008, any volatility spikes above 30% were considered to be high.
Recent volatility levels (which are relatively low compared to fall 2008) remain far above the
30% level. To give you an idea about how much more volatile the VIX is than the SPX, on
January 16, 2009, the 20-day historical volatility of the VIX (represented by the blue line) was
84.17%. To put this in perspective, on October 22, 2008, the 20-day historical volatility of the
VIX was over 243%. This is considerably higher than the volatility youll find for all but the
most volatile stocks in the marketplace.
Why has the VIX been so volatile?
As I mentioned before, the VIX is intended to measure the implied volatility of the SPX. Implied
volatility is an annualized standard deviation. On October 22, 2008, the VIX was at 89.53 and
the SPX was at 877.00. This level of the VIX implies that over the next 30 days, options prices
on the SPX are indicating that there is a 68% chance (one standard deviation) that the range on
the SPX will be between 651.90 and 1102.10 over the next 30 days. That is a forecasted potential
increase or decrease of over 25% in 30 days (nearly 90% on an annualized basis). If you imagine
the level of investor anxiety that would exist if the SPX dropped 25% in a month, I think you can
see why the VIX is so much more volatile than the SPX. Now imagine the change in price of
VIX options if the SPX dropped 25% and I think you can see why the implied volatility of VIX
options has been so high.

Source: StreetSmart Pro, as of 01/16/2009.

As shown in the chart below, even the 20-day historical volatility of this stock (represented by
the light blue line), which is considered wildly volatile, has not exceeded 73% since the peak
volatility in mid-October 2008. My point is that almost nothing appears to be more volatile than
volatility. Now, what can you do with this information?

Source: StreetSmart Pro, as of 01/16/2009.

How to use the VIX to take a position on volatility
Trading options on the VIX gives you the opportunity to trade one of the mostif not the most
volatile issues in the entire marketplace. This creates a number of potential opportunities that
were unavailable prior to the creation of the VIX. You no longer have to establish expensive long
straddles and strangles or short butterflies and condors to take a position on volatility. If you
expect increasing market volatility (which has historically occurred during a sharp sell-off), you
can use a long call option on the VIX to attempt to capitalize on your forecast. Similarly, you can
replace negative volatility strategies like short straddles and strangles or long butterflies and
condors with a long put option on the VIX. A long put on the VIX will likely gain value as
overall market volatility decreases (which has historically occurred during a rally), and, since
this is a single long put trade, it can typically be executed with less risk and lower transaction
costs than multi-leg strategies.
How to use the VIX to establish a potential hedge
Another way to consider using VIX options is as an insurance policy or hedge against a sharp
market move. In theory, implied volatility is non-directional; in practice, it has typically
demonstrated far more sensitivity to downside moves than to upside moves. This means that
instead of attempting to hedge a portfolio of stocks by buying an ETF or index put option, you
may be able to do it more cheaply by buying a VIX call option. While no option strategy can
provide a perfect hedge to your portfolio unless you own shares in the exact proportions of the

benchmark index, historically the VIX has appeared to overreact to market downturns. As a
result, VIX calls could rise in value much faster than a typical index put option, potentially
allowing you to offset some or all of the losses in your stocks at a much lower cost.
How a VIX hedge might work
If you purchase a long put option, it will likely have a delta (ratio that compares the change in
the price of the underlying asset to the change in the price of a derivative) of less than 1.00,
unless it is deep in the money. This means that the put will gain value at a rate that is less than
dollar for dollar with the drop in the index. For example, assume you had a portfolio that was
closely correlated to the SPX. An SPX put option with a delta of .70 will only gain .7% for
every 1% lost in the SPX. However, because the VIX tends to react in an amount that exceeds
the movement in the SPX, the VIX might increase 1.5% or more with a drop in the SPX of 1%.
If you owned a call option on the VIX with a delta of .70, it might increase in value at a rate of
70% of the increase in the VIX. That would be .70 x 1.5% = 1.05%. This exceeds the 1%
decrease in the SPX, which suggests your hedge might potentially exceed the loss incurred.
Note: This is only an example and cannot be guaranteed. VIX options are closely tied to futures
contracts on the VIX; as a result, their valuations can be affected by a number of factors. It is
possible for VIX options to react in an amount that is greater or less than the move in the SPX.
Other measures of volatility
Watch any of the financial channels and youll always hear the experts carrying on about
volatile markets, but how do you measure such an arbitrary thing? The VIX is not the only
volatility gauge out there. Volatility on the Nasdaq can be measured with the CBOE Nasdaq
Volatility Index (VXN), and volatility on the Russell 2000 can be measured using the CBOE
Russell 2000 Volatility Index (RVX) both of these trade options, too.
Understand VIX options before trading them
Be careful when trading the VIX. Standard pricing models based on the old Black-Scholes
formulathe first widely used options pricing formulawont work the same way for VIX
options as they do for other options because VIX options are a second derivative. Consider that,
at least in theory, any stock can go to zero or infinity. Without too much thought, its pretty
obvious that volatility cant go to infinity, and it also cant go to zero. This means that the
lognormal distribution curves that options pricing models are based on dont really apply,
because the upper and lower tails will be much fatter than those of an individual equity.
Additionally, since volatility tends to revert to the mean, even when it spikes sharply higher, it
isnt likely to remain there for very long. As a result, you should always watch your position
closely, as exit opportunities may be short-lived.
Potentially complicating matters further, the price of VIX options is based on the anticipated
level of the VIX at expiration rather than the current level of the VIX. This means youll
probably see a closer correlation of price to the VIX futures on the CBOE Futures Exchange
(CFE) than to the actual level of the VIX index. In other words, prices for VIX options
expiring in the month of May will most closely reflect the level of the June futures contract,
while prices for VIX options expiring in August will most closely reflect the level of the
September futures contract. Dont assume that VIX options reflect the current quote of the VIX.
It may appear that options with later expiration dates are cheaper than options with earlier

expiration dates, or that the options are trading at a discount to the intrinsic value, neither of
which is likely true.
Even more confusing is that VIX options expire on the Wednesday that is 30 days prior to the
third Friday of the calendar month immediately following the expiration month. This means that
the expiration date could be either prior to or subsequent to the regular equity option expiration,
depending on the month. To learn more about the nuances of VIX options, we encourage you to
visit the CBOE website and read the VIX White Paper.
As always, for additional information on options strategies or for assistance using Schwabs
options trading tools and platforms, please call a Schwab Options Specialist at 800-435-9050.
The VIX: A rapid rise to prominence
The VIX was a revolutionary concept when first introduced in 1993 because, for the first time
since exchange-traded options came into use (some 20 years prior), traders had a way to
measure and track the near-term implied (anticipated) volatility of the marketplace. The original
VIX was calculated using the implied volatilities of near-month put and call options that were
trading on the S&P 100 (OEX).
The VIX remained true to its original formula for about 10 years. Then, in 2003, an important
change took place to ensure that VIX remains the premier benchmark of U.S. stock market
volatility, according to the CBOE. In short, the formula was essentially changed so that it
includes more options and different weightings, and it began using S&P 500 (SPX) options
instead of S&P 100 options to better represent a broader section of the market. The CBOE
provides retroactive calculations on the VIX all the way back to 1986 using the new formula. To
appease those people who dont like change, the CBOE even created a new indexCBOE S&P
100 Volatility Index (VXO)which continues to use the old formula.
At the time of the formula change, there was also talk that one day derivatives products might
be traded on the VIX. As promised, VIX futures began trading in early 2004 on the CBOE
Futures Exchange (CFE). For those of us who are partial to the listed options markets, the
bigger news was the introduction of VIX options on the CBOE in February 2006. The
recognition of the VIX among options traders, combined with recent spikes in volatility, has
caused these options to rise in popularity quickly since their introduction.