Volatility is at the heart of tastytrade’s trading style. Understanding the relationship between different trading vehicles is part of what we consider to be “market awareness.” To further our market awareness around volatility, we took a look at the relationship between the SPX, the S&P 500 index, and the VIX, the CBOE Volatility Index.
The VIX is a volatility measure derived from SPX option prices. When SPX option prices are higher because traders expect larger SPX price changes in the future, the VIX is high. A high VIX is a signal for us that option premium is rich, allowing us to “sell volatility” and capture that premium as potential profit. When SPX option prices are lower because traders expect smaller SPX price changes in the future, the VIX is low. A low VIX is a signal for us that option premium is lower, and that there isn’t as much reward for selling options. That’s why we may choose a long volatility strategy. But what role does volatility play in trading and what is “high” or “low”?
Volatility allows us to calculate the expected move in an underlying asset over a defined period of time. We know from past studies that volatility tends to overstate the magnitude of future price changes. As volatility increases, the amount by which that expected move is overstated also increases. This increased exaggeration has the effect of causing options to become more expensive. It also results in options with strike prices far away from where the underlying currently trades to become expensive on a relative basis.
On a historical basis, VIX has a mean of roughly 18, give or take a couple points. This is crucial because we believe that volatility is mean reverting. Therefore, when VIX is trading above its mean, we say volatility is becoming increasingly rich. We want to sell that exaggeration, if you will. And for those not paying attention, when VIX is below 18, we say volatility is becoming inexpensive or cheap. Typically, we look to buy inexpensive volatility.
VIX and SPX have an inverse correlation. When the market is falling, volatility tends to rise, hence the VIX’s other name, the “fear index”. To better understand the exact correlation between SPX and VIX, we conducted a study (hey, our research team isn’t paid to sit around and just look pretty -- that compliment should buy me at least one favor from them).
We looked back at the relationship between VIX and SPX since 2006. Each day that the SPX moved greater than 0.5%, we measured the ratio between SPX and VIX. We then filtered results based on the past 1, 5, and 10 years. That’s right, don’t tell us we don’t know how to have fun!
What we found was that over the past 10 years, a -12 point move in SPX tended to result in a 1 point move in VIX. In the past 5 years, that ratio was -13:1. If we look at just the last year alone, the ratio is -15:1.
These types of studies are invaluable because of both their actionability and contribution to market awareness. Knowing that VIX should move up one point for every 15 point fall in SPX provides an expectation where VIX will be if SPX falls 15 or 30 points. At the same time, if VIX ticks up a point intraday and SPX is relatively flat, perhaps it is a sign the market is about to fall. In that respect, our market awareness just became sharper.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Market Measures | Relationship Between SPX and VIX: March 22, 2016