The Hindu Business Line : Trader's Corner

One term that has been frequently bandied about in the recent market correction is CBOE (Chicago Board Options Exchange) VIX. Investors tracking the global markets closely over the last one month have been forced to look at the VIX reading every morning along with the gyrations of the US markets.

The VIX or the volatility index was introduced in 1993 and since then it is widely recognised as the best indicator of the investor sentiment and market volatility. The VIX is calculated based on the implied volatility of nearby and second nearby S&P 500 index options spanning a wide range of strike prices. It uses both at-the-money and out-of-money puts and calls to derive the expected volatility.

Implied volatility of options is the estimated volatility of the underlying security. Implied volatility increases when the markets are moving down and the reverse holds good when the markets are moving up. This is because investors tend to get complacent when the markets are rising steadily and hence the volatility is lesser. When the markets start falling the panic level is higher and the expected volatility too rises.

It is probably for this reason that the VIX is also called the ‘investor’s fear gauge’. Since it tracks the investor’s expectations of the future volatility on a real-time basis, the index represents the changing sentiment among the investors pretty accurately. The reading of VIX reached almost 45 in 1998 as the LTCM (Long term Capital Management) crisis exploded. It took a few months for the investor’s fears to abate and the VIX to return below 20. The World Trade Centre bombing also made the VIX climb above 45 as the investors fear level reached the zenith.

The recent noise being raised is due to the VIX reading hitting 37.6 on August 17. The last time the VIX moved close to 30 was in March 2003. The average reading for VIX since 2004 has been between 12 and 16. The spiking of this indicator means that the investors are expecting the markets to move lower. — Lokeshwarri S. K.

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