Advanced Guide to the Fear Index and Options Volatility

Investors often turn to the Cboe Volatility Index (VIX) during turbulent markets to gauge market sentiment. Some even refer to the VIX as the "fear index," as it tends to spike significantly during sharp market declines. Additionally, investors can trade futures and options on the VIX. However, despite its popularity, few truly understand how this measure of options volatility works, what it signifies, how it is calculated, and how to estimate its most accurate value.

The "Rule of 16" for Volatility

Cboe introduced the VIX in 1993 as a weighted measure of the implied volatility (IV) of S&P 100 Index (OEX) options. In 2003, the calculation shifted to the more actively traded S&P 500 Index (SPX) options, replacing the OEX options. Since its inception, the VIX has become a premier indicator of investor fear and overall market volatility.

Under the Rule of 16, if the VIX trades at 16, the estimated daily movement of the SPX is 1% (since 16/16 = 1). If the VIX is at 24, daily volatility might be around 1.5%, and at 32, the SPX might experience daily swings of 2%, according to the rule. The Rule of 16 derives from the square root of 252 (the number of trading days in a year), which rounds to approximately 16, giving the rule its name.

The Rule of 16 also works in reverse—investors can “annualize” daily readings by multiplying them by 16. For example, if a stock frequently moves by 1.8% per day and this accurately reflects its inherent volatility, investors might estimate an annualized volatility of 1.8 x 16 = 28.8%. Since volatility is a key variable in options pricing models, comparing expected volatility with current IV can indicate whether options are overpriced, underpriced, or fairly valued.

Volatility Skew

Volatility skew can occur at different strike prices, expiration dates, or both. For instance, in index markets, out-of-the-money (OTM) put options often have higher IV than OTM calls, resulting in higher premiums for puts. This skew is sometimes attributed to large institutional investors’ demand for portfolio protection (index puts) during uncertain times or the belief that markets tend to fall faster than they rise.

1. Term Skew: When options on the same underlying security have significantly different IVs across expiration dates.

2. Price or Strike Skew: When options on the same underlying security have significantly different IVs across strike prices.

Skews are also seen in scenarios with different expiration months. For example, if a biotech company awaits regulatory approval for a blockbuster drug, short-term options may have higher IV than long-term options due to the anticipated event.

Volatility skew can sometimes indicate the direction of perceived risk in the underlying security. Supply and demand dynamics often determine the existence and extent of skew. If there is no heightened demand for certain strike prices or expiration dates, skew will not occur, as IV is largely influenced by these factors.

In the context of individual companies, various events can influence skews, such as upcoming earnings reports, dividend announcements, or corporate actions. Mergers or acquisitions may also play a role. In index markets, global economic trends, market volatility, and changes in risk perception are common drivers of IV variations across expirations or strike prices, leading to skew adjustments.

Key Takeaways

Volatility readings define statistical trends but do not predict outcomes with certainty. They reflect investors' perceptions of the likelihood of certain events, not guaranteed occurrences. Nevertheless, tools like the VIX, the Rule of 16, and skew analysis can provide valuable perspectives to help investors understand market sentiment and risk.