Tuesday, December 30, 2008

Volatility Index Coming Down From Oct-Nov Peaks

One of the most important but underreported financial indicators is the CBOE’s Volatility Index (^VIX), which measures the market’s expectation of future volatility in stock prices. (The CBOE has written a nice technical paper describing how it is calculated here.) Traditionally, the annualized volatility of the S&P 500 has been 20%, but in both October and November the VIX reached an apocalyptic 80%. The huge drop in stock prices is bad, but it would be a lot better if the market thought that the major gyrations were mostly in our past. So the good news is that the volatility index has retreated to 45% (see chart above).

Now, 45% is still more than twice what it “should” be. But it’s at least moving in the right direction. When it drops below 30%, it will be a strong indication that the market correction is complete and we’re back to business as usual.

From Ian Ayres at the
Freakonomics Blog


At 12/30/2008 10:49 AM, Anonymous Anonymous said...

I once read that if you really want to know if the economy is on the way up or down you should follow an index that tracks furniture.

I think the theory is that if furniture sales are picking up then housing is picking up and people feel more confident about their work situations. Conversly, if furniture sales are in decline then housing will probably be slow and people's confidence about their work situation will be more negative.

At 12/30/2008 2:36 PM, Blogger wcw said...

Oh, save me. Lawyer economists should really resist the temptation to pretend to be traders. I have traded options to make money before (currently I trade them only for my tax-deferred accounts), and that article is all kinds of wrong.

- the VIX is anything but underreported. It is massively overreported compared to its utility as an indicator of anything other than recent historical volatility. Moreover, it is deeply misreported, especially when it is called a 'fear index'.
- the VIX does not predict the future. The VIX represents traders best estimated of near-term volatility. The best estimate of near-term vol is recent historical vol. Which makes the VIX almost purely and perfectly backwards-looking.
- traders best estimates of near-term volatility vary from recent historical volatility now and then. The Xmas holidays are one of those times, because there are so many down days (reducing trading days versus calendar days to expiration) and because everyone takes time off, reducing volumes and inculcating the usually accurate expectations of sleepy markets.
- there is no #@%$! "should" in the market. If Ayres believes he sees a mispricing, he can trade on it. Short VIX futures, sell OEX options, change his trading algorithm to fade moves, whatever he likes. This kind of article is dumb, especially -- as here -- when it is mostly wrong.

On the bright side, articles like these give me hope there will always be idiots to take the other sides of my trades.


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