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Understanding Volatility and the VIX ‘Fear Gauge’: QuickTake

Volatility Is Up. Here’s How It Works and Why It Matters

Understanding Volatility and the VIX ‘Fear Gauge’: QuickTake
A data graph tracks the movement of stocks on the stock exchange in Germany. (Photographer: Alex Kraus/Bloomberg)

Markets go up and down; the amount they move is their volatility. In normal times, traders like a dose of volatility, and betting on its levels has become a market of its own. When times aren’t normal, like early in the Covid-19 pandemic, the worry was that extreme financial turbulence was feeding on itself -- prompting the U.S. Federal Reserve to step in. Now with the central bank set to reverse course amid surging inflation, the effects can be seen playing out again across stocks, bonds and commodities.

1. What is volatility?

Basically, the rise and fall of prices in financial markets. Downward moves tend to get more attention and be more associated with volatility, as they also tend to fuel concern about what’s coming next.

2. How is it measured?

The most prominent tracker is the Cboe Volatility Index, or VIX, which is sometimes referred to as the “fear gauge” because it tends to rise when stocks go down. It’s a market estimate of future volatility.

3. How does the VIX capture fear?

It’s compiled based on how much traders are willing to pay for options on the S&P 500 Index. Options are contracts that give the holder the right, not the obligation, to buy securities at set prices by a set date when the underlying asset reaches set levels; traders often use options and other derivatives as insurance policies against market fluctuations or to bet on the moves themselves. The higher the price of the option, the bigger the fixed cost, and therefore the larger the move needed to generate a return that will make it pay off. So option prices reflect the size of the swings -- the volatility -- traders expect. Say a trader pays $5,000 for an option betting on yen moves, and say that contract shows implied volatility is about 8%. If some other investor pays $10,000 for the exact same option, then the implied volatility level jumps to about 10%.

4. What’s ‘normal’ for stock volatility?

The long-term average for the VIX is about 19.5 and its median about 17.6, with its lowest levels being in the 8-10 range. Its intraday record high is 89.53, set on Oct. 24, 2008, at the height of the global financial crisis. On March 16, 2020, it closed at a record high of 82.69. Some refer to the VIX as “mean-reverting” -- it tends to go back toward its average over time rather than stay at extremes.

5. How do people invest in the VIX?

They can’t invest directly in the VIX, which is just a number, but can make bets on which way the index will go by using futures, options or VIX-based exchange-traded securities. In fact, the emergence of a whole crop of products tied to the VIX in recent years has led to questions about whether VIX trading is itself influencing the index or volatility as a whole.

6. Is trading volatility like trading stocks?

They have similarities, including the ability to go short or long. “Short volatility” is a bet that volatility will continue to go down, or at least stay at very low levels. “Long volatility” is the opposite, a wager that it will increase.

7. Is there a lot of money invested in volatility?

Apparently yes. In addition to the amount invested in VIX derivatives and exchange-traded products, many investors use strategies that are contingent on volatility. A 2018 paper estimated the invisible hands of volatility-sensitive investors controlled more than $1.5 trillion. They include hedge funds, mutual-fund managers, risk-parity funds, banks, dealers and market makers, according to JPMorgan Chase & Co. Assets in volatility-contingent strategies swelled in the aftermath of the global financial crisis, aided by an extended lull in market swings and an implicit central-bank put, or promise to put a floor under markets during the turmoil.

8. What’s the problem with that?

As long as market swings remain under control, these players continue to buy. But when a volatility shock arrives, they start to sell, and the higher their positioning, the faster they unload. The problem comes because dealers and market makers -- those tasked with absorbing these flows -- also react to changes in volatility. When it’s high, these intermediaries widen bid-ask spreads to reduce their risk. This self-reinforcing cycle -- what some in the market call a doom loop -- could help explain the link between the seemingly indiscriminate selling, the shallow liquidity and the violent shudders that rocked assets as pandemic fears spread in early 2020, extending well beyond the stock market.

9. What does that add up to?

Markets could be vulnerable to a “correlated asset-market crash.” That’s what Vineer Bhansali and Larry Harris predicted might result from the boom in trades betting against price swings in the 2018 paper. According to JPMorgan, equilibrium can be restored, but only when prices reach a level where volatility-insensitive players -- like pension funds, insurance companies and sovereign wealth funds -- step in.

10. What bigger-picture factors influence volatility levels?

Market fundamentals and mechanics are two major factors in volatility levels. Day-to-day news that affects markets overall will also affect volatility, like a geopolitical event or earnings reports. Things like clarity -- or lack thereof -- on Fed policy can also influence it, because it influences how confident traders can be in what the situation will look like weeks or months in the future. The leadup to likely rate hikes by the Fed this year has elevated rates volatility in particular, as measured by the ICE BofA MOVE Index, which tracks swings in Treasury options prices. 

Understanding Volatility and the VIX ‘Fear Gauge’: QuickTake

The Reference Shelf

  • A QuickTake on what the terms contango and backwardation mean for the VIX, and why the latter can set off alarms.
  • A Federal Reserve primer on global volatility.
  • How volatility could turn from a market foe into its friend.
  • Volatility Inc.: A look inside Wall Street’s $8 billion time bomb.
  • A historic volatility gap has U.S. rates traders on tenterhooks.
  • A simple investment strategy, doomed by a one-direction market.
  • How an odd spike in Wall Street’s “fear gauge” awakened a manipulation debate; and how VIX plaintiffs lost a bid to unmask traders tied to the spike

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