The VIX Is A Volatility Ghost

Professor Robert Engle´s article on market volatility (“The threat that won´t go away”, Financial Times May 25th) toes a traditional line by equating the VIX index with, well, volatility. But the VIX, contrary to what many have believed and have been taught for years, is not quite equal to volatility. In fact, it may be miles away from being even a mild reflection of turbulence. I have a chapter devoted to this in my new Lecturing Birds On Flying.

The VIX has essentially been two things throughout its life, and none of them can be reasonably labeled as volatility. Initially, the CBOE calculated the VIX from the famous Black-Scholes option pricing model, by reverse-engineering the formula´s volatility parameter from quoted equity option market prices. That is, during its early years the VIX was what´s called “implied volatility”, which is supposed to represent the volatility expectation that traders input into the (supposedly employed) model; but implied volatility can´t be seen as a window into expected mayhem, for two basic reasons: traders may not be using the model when pricing options (who can guarantee that that´s always the case?), and even if they are the volatility input would contain lots of other stuff besides pure expectations (something called the volatility smile, glowing out there since October 1987, definitely tells us that implied volatility can´t equal true volatility expectations).

When the CBOE changed the calculation method in 2004, the VIX became the theoretical price for a type of derivative contract known as “variance swap”, obtained through very sophisticated mathematical ruminations (borrowing from prior work by Goldman Sachs quants). The new VIX does not assume the use of Black-Scholes in real life, and does not reverse engineer from a model. While the old VIX could somehow claim to represent implied volatility (if traders are using Black-Scholes), and thus be a window into traders' opinions, even if not an exact mirror into their volatility expectations, the modern VIX is not even implied volatility. It is not directly implied from option prices. Rather, the VIX is now linked to those prices through a mathematical sleight-of-hand, almost accidentally. When market option prices change, the VIX will change, but we can't imply that the VIX would reflect any precise information (such as volatility expectations) that those prices may or may not contain. There simply is no reverse engineering going on. No direct, incontrovertible peeking into traders’ minds here. The VIX is a wholly opaque and very dubious guide to the opinions and feelings of financial pros. If we see the VIX explode (tumble) all we can say with honest certainty is that the prices of some S&P 500 options are climbing (declining) quite steeply. We can't honestly imply anything about fear or exuberance levels along Wall Street.

Sadly for those yearning for precision-promising certainties, the VIX has never measured what we were told it could measure. By endowing it with fake powers, we are letting a deceitful ghost influence our markets.