Emotion in Motion

I would do anything
To hold on to you
Just about anything
Until you pull through
--Ric Ocasek

The Volatility Index (VIX, VXO) estimates the 'implied volatility' baked into S&P option prices. When market participants sense big pending movements in stock prices, they pay more for options, which sends implied vols higher.

Volatility indexes provide useful gauges of investor sentiment. When markets move higher, investors are often less willing to hedge their long positions with put options (when you buy a put against a long stock position, you are essentially buying insurance to protect your position against a price decline) or to speculate in puts outright. Less demand for options causes implied vols to fall.

Declining vols are commonly associated with conditions of 'complacency' in markets, as investors are less willing to pay for insurance to protect their long positions.

Typically, when market prices decline, investors suddenly wake up to the need for downside protection (or to speculate on lower prices by buying puts outright). The lower prices go, the more investors are willing to pay up for put options, which in turn drives implied vols higher. As such, rising vols commonly reflect 'fear' in markets.

Take a look at the two charts below. First is a chart of the S&P 500 (SPX) over the past five years.

Second is a chart of the VXO over the same time period.

Note the inverse relationship between the SPX and the VXO--particularly during periods where the SPX declined. The VXO hit its zenith during the waterfall decline in stocks in late 2008, early 2009--indicative of major fear in the markets. Note also that this fear was reactive--implied vols didn't spike until after prices began cascading lower.

Since the March 2009 stock market lows, the VXO has been generally grinding lower while the SPX has been grinding higher (interrupted by last spring's 'flash crash' phase). The VXO currently stands at multi-year lows--indicative of significant complacency.

Please note that the VXO is not an effective forecasting tool. For example, just because implied vols are relatively low today does not necessarily mean that a market decline is eminent.

Instead, volitility indices are better regarded as coincident indicators--more reflective of current levels of collective sentiment rather than of future sentiment or its consequences.

Nonetheless, smart market participants keep an eye on volatility indexes in order to gauge sentiment in the here and now.

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