What Does the VIX Mean?

In a couple recent blog posts looking at the state of the stock market, I have referred to the VIX. It has occurred to me to dig a little deeper to find out what the VIX measures and how it can be interpreted. The results were a little disappointing, but not altogether unsurprising.

First, the VIX is a measure of expected volatility, when I thought it was a reporting of experienced volatility. I didn’t realize that the VIX is quoted in percentage points.  That makes sense, since it’s a measure of the implied volatility found in S&P 500 option contracts. According to Wikipedia (fount of all knowledge), the VIX “translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period.”

It was pointed out that volatility doesn’t necessarily mean that markets are expected to fall. A market that is expected to quickly rise will also translate to higher volatility. But what the VIX is reporting is people’s expectations. When people expect the market to rise, they expect it to rise consistently and orderly. When people expect the market to fall (continue falling), they expect the worst.

So the VIX turns out to be similar to a measure of sentiment. During the market crash, sentiment was poor and the VIX was high. Alternatively, when the market appears to be rising, sentiment is good and the VIX is low. But since investors, even professional traders who deal in S&P 500 futures, have been shown to be unable to predict the market behaviour over the coming 30 days, the VIX reflects current sentiment and is unuseful as a predictor of future market returns.