Observations & VIX Interpretation

Fig 1: S&P 500, VIX, ATR(20), and ATR(20)-VIX Difference Histogram

The VIX is an indicator distributed by the CBOE which uses the out-of-the-money put and call prices for the front and next months to forecast implied volatility for the next calendar month.

The reality, however, is that it’s largely a reflection of the past calendar month.  This is demonstrated by plotting Wilder’s Average True Range (ATR) of the past 20 trading days (approximately one calendar month) against the VIX.  The shape of the two curves are almost exactly the same.  The divergences are in magnitude, and the apparent under-pricing of risk in 2000 and 2008 are very interesting.  Consequently, I’ve plotted a histogram of the difference between the two.

The VIX At Bottoms

Despite its most obvious usefulness more as a mirror rather than a crystal ball, the VIX has served as a bottoming indicator for both strong secular declines in the past decade.

2003 Bottom

2009 Bottom

Observe that in both instances, the VIX peaked before the ultimate bottoms in price & time.  Options writers are the most sophisticated of investors, and they clearly bet on the bottom.  Perhaps it was obvious to them what is obvious now:  oil, gold, silver and Asian equities were well off their ultimate November and December lows.

The other supporting theory is Max Pain Theory, which theorises that since options writers are the most sophisticated (and likely the largest) players, they will simply manipulate the market to make the most money.  Max Pain is the closing price at expiry of a security which gives the largest total payout to options writers.  I haven’t seen or conducted a study on the forecasting power of this, but I wouldn’t discount it as a vector of influence on equities;  the necessary supporting data that options writers make out like bandits was covered in depth by CXO Advisory.