How the VIX Reads S&P 500’s Future

In preparation for a potentially close U.S. presidential election it may be beneficial to review how the CBOE Volatility Index (VIX) played out prior to the Brexit vote as well as what this measurement means. On June 6, 18 days prior to the Brexit vote, the VIX closed at 13.65, a relatively low reading for volatility. Within a week, the VIX would reach 21.00, and by voting day on June 24 it had reached 25.76 — that's a 90% jump in value in just over two weeks. Market participants who were watching VIX knew something big may be coming.

In contrast, the S&P 500 was relatively flat in the weeks preceding the Brexit vote. If market participants were simply watching the S&P 500, they would have had no idea how risky the future may be.

Given this example, it's no surprise that the VIX has become a bit of a rock star. It is one of the main scrolling tickers on CNBC. It has the second most active options activity, only behind the S&P 500 Index. In addition, 20 ETFs track it (top five tickers: VXX,XIV,SVXY, UVXY andTVIX), with total AUM of $4.5 billion and daily volume of around $135 million.

Why the popularity? One answer is because the VIX is a very efficient way — in fact, one of the only ways — to understand perceived market volatility at any given moment.

Stepping back for a moment, let's recap the definition of volatility: It is a measurement of dispersion of results around the mean for whatever you may be measuring — investment returns, archery practice, your dating life, etc. The higher the volatility, the more unpredictable results are. Conversely, low volatility suggests a tighter band of results around the mean and more predictable results.

Volatility provides a good measurement of potential risk and is a powerful tool to use in making decisions. As a general rule, people want predictable, controlled outcomes (a tendency known as risk aversion) in important areas of life. An outcome that is perceived to be relatively volatile and thus less predictable — such as investing in space flights to the moon or a vacation spot with widely varying weather — has to offer significant rewards for the trouble, such as a chance to change human history or at least a free breakfast buffet with all-you-can-drink mimosas.

How Does One Measure Volatility?

That depends if one is talking about historical volatility or future expected volatility (Future expected volatility is known as implied volatility in the finance industry).

In calculating historical volatility, one looks at the average of all results (for whatever time period is being evaluated) and then compares how much each result differs from the average of all results — the more each result differs from the average, the greater the volatility for the population.

For those who find history boring and instead want to see into the future, implied volatility is the way to go: It reflects the expected future dispersion of results around the future average. Implied volatility is a variable used in options pricing, and therefore implied volatility can be reverse calculated from the market price of an option. All else being equal, the higher the price of an option, the greater the implied volatility the market is assuming for that security.

Illustrating Volatility

Here's an illustration using Apple (AAPL) stock. Let's say the expected average return over the next year is 5%, and the current implied volatility is 10%. Then expectations are that 68% of the time (for those statistics buffs out there, one standard deviation, assuming a normal distribution of returns) AAPL stock would generate returns of between -5% and +15% over the next year. Now imagine that instead of implied volatility being 10%, it was 30%. In that scenario, 68% of the time AAPL would return between -25% and +35% in a year. That's quite a range.

So the next time you receive an analyst report with an expected return over the next year, find out what the volatility is and apply it to that return. That is why analysts often miss their estimated numbers by such large margins. What you will typically see is how difficult it is to make accurate stock predictions in the short run; once you take volatility into account, a stock's actual performance can swing widely from what is expected.

Figures 1 and 2 illustrate these concepts: one distribution curve with 10% volatility and one with 30% volatility.

Notice the dotted vertical lines in each graph. They represent standard deviations, a statistical tool used to demonstrate distance from the average. Like volatility, standard deviation is calculated by determining how far on average each result is from the mean.

In a normal distribution, 68% of results are expected to occur within one standard deviation of the mean, either up or down. Thus, in the top chart, 68% of results occur between -5% and +15%. Ninety-five percent of all returns should occur within two standard deviations, and 99% of all returns should occur within three.

Note that in practice, the stock market is believed to have "fat tails," which means the odds of a wild and crazy outcome (greater than three standard deviations away) are higher than the 1% probability that would be the case in a normal distribution.

A scatter plot is another way to view volatility. As can be seen in Figures 3 and 4, a 10% volatility is more clustered around the mean relative to the 30% volatility.

Volatility and the VIX

How does this relate to the VIX? VIX is an index designed to reflect how volatile the S&P 500 is expected to be over the next 30 days. The VIX is calculated using options on the S&P 500; thus, the same implied volatility that is priced into options on the S&P 500 is used to power the VIX.

In a sense, the VIX index communicates to the world what otherwise would only be known to options traders and options investors: how risky the major market players perceive the stock market to be over the next 30 days. When the VIX level increases, it represents a market consensus that there is more potential risk in the market over the next 30 days, and vice versa.

When major events loom on the horizon, such as the Brexit vote that occurred earlier this year or the upcoming U.S. presidential election, it can be insightful to watch the VIX level to predict how rocky or calm the near future is expected to be.

— Read Jeremy Siegel on Biggest Threats to Market, Impact of Election on ThinkAdvisor.