The Market's Heart Monitor

While the precipitous drop of the Dow this year has garnered much financial media hand-wringing recently, another index has also attracted attention, especially in the blogosphere: the Chicago Board Options Exchange Volatility Index, a.k.a. the VIX. What does it mean to track "volatility," and why is it important?

Volatility, as bad as it sounds when talking about something like a marriage or digestion, isn't as much of an economic boogeyman as its name would suggest. Think of volatility as the market's heartbeat. A huge spike would be dangerous, as would no movement at all; instead, a certain amount of constant movement within a prescribed range is essential. The VIX, then, is sort of the market's heart monitor. Analysts can gauge the health of the market by watching for aberrations in its movements.

The index represents the market's predicted movement for the upcoming 30 days, which is referred to as "implied volatility." It's calculated based on the prices paid for options -- contracts to buy and sell in the future -- on the stocks that make up the S&P 500. Both call (buy) and put (sell) options act as a kind of insurance against price movement.

For instance, if I have a call option for Acme Anvil Co., that means I have the option to buy a certain amount of their stock at a predetermined price during the next 30 days. If the price of Acme's stock soars during the next month, I beat the system because I get to buy the stock at the lower, preset price.

This is similar to the way many Americans prepay for their home heating oil during the winter, with one key difference. If I've locked in to buy my oil at $3 a gallon and the market price goes down to $2 a gallon, I'm stuck paying the higher price. This kind of arrangement is called a "futures contract." If I had an option instead of a futures contract, I'd be able to pick the cheaper of the two alternatives.

Likewise, if I have a put option for Acme, that means I get to sell the shares I already own at a predetermined price during the next month. If I'm worried about something dragging down the price of those shares -- say, a lawsuit from an angry coyote -- I'm going to pay for this option because it lets me sell at the higher price even if the value of that stock drops like an, um, never mind.

Traders are willing to pay more for this option "insurance" if they think the market's going to go haywire; as a result, it's possible to get an aggregate snapshot of how risky they think their positions are by tracking option prices.

The number itself is an annualized figure, although the VIX looks ahead for only 30 days. What does that mean? It means that the percentage by which the stock market is expected to fluctuate over the coming months is only a fraction of the index value itself. Want to crunch the numbers? Grab the back of an envelope and divide the VIX value by the square root of 12 (about 3.46). For instance, a VIX of 45 yields a number of about 13, which means the stock market could go up or down by 13 percent over the next month. People who eat and breathe math can finesse these estimates further, but this quick calculation works for most casual VIX watchers.

While there's no ideal number, economists generally breathe easy when it's around 20. They've done a lot of hyperventilating lately; since 2009 began, the VIX has been hovering in the 40s, popping over 50 on a pretty regular basis. Over the past year, the VIX has seesawed from about 15 to 90. On Oct. 24, it traded at its highest number on record.

It's easy to see why economists fret about a high VIX number; it means there's a storm on the horizon. On the other hand, a too-low VIX also worries them because it implies that market players aren't paying enough "risk insurance" and could face a loss if the market suddenly zigs when it's supposed to zag. A low VIX also telegraphs that nobody expects the S&P 500 to rise substantially in the near future -- if a big rally were expected, there'd be a mad scramble for call options so investors could lock in lower prices.

Because the index is based on the broad-based S&P 500, as opposed to a handful of stocks, the VIX has the benefit of crowd-think to enhance its predictive accuracy. Even so, it's not a crystal ball. Because the VIX lumps together puts and calls, it can't forecast market increases or decreases specifically, only that there are bound to be changes. While a sudden spike in the VIX most often correlates with a plunge in the stock market, a VIX increase could signal a recovery that's taking place in fits and starts, as well.

It can also be prone to exaggeration on the negative side if investors are skittish. Realistically, a lion skulking on the savanna is going to pick off only one or two gazelles, but the whole herd will still take off running at the first whiff of the big cat. Those periodic flashes of irrationality have led to the VIX being slapped with the nickname of "fear index" in the financial media schoolyard. While it's not entirely inaccurate, it's an incomplete characterization at best. Volatility can be priced and managed; in fact, there are even options on the movement of the VIX itself.

Recently, market watchers have been griping that the VIX has lost its predictive mojo. For example, it didn't reflect the early March epic tumble; while the index continued to exhibit hypertension, hovering around 50, there were no jarring spikes along the order of what happened last October. Following Tuesday's rally, the VIX dropped below 50 and has been inching downward since, though it's still high by historical standards.

This raises the question of whether the index is still relevant during these anything-can-happen times. The short answer is yes, with an asterisk. The VIX has been elevated for a number of months in part because there simply hasn't been a long-enough period of relative calm for it to reset at a historically "normal" level. There's also the hypothesis that essentially says we've gotten used to living under the financial equivalent of threat level "orange" and have factored that into trading behaviors. Normalizing the surprise factor means it will take a bigger jolt to shock the VIX into a spike.

Some economists say the VIX should be, if not replaced, then supplemented with other metrics that give a more complete assessment of volatility. Robert Engle, a professor at New York University's Stern School of Business, is one such academic experimenting with an alternate system. Dubbed the Vlab and rolled out in a beta version earlier this month, the tool draws on asset prices rather than options prices to measure volatility. A user can look at volatility in prices on Dow Jones or S&P 500 stocks, currency exchange rates and other publicly traded assets.

The advantage here is that analysts have a much larger pool of data to draw from compared with the relative sliver of the market represented by S&P 500 options. More data means a more accurate look at real-time volatility. On the other hand, the VIX has the advantage of being able to look into the future. Is one more important than the other? Not necessarily. Think of the fable about the blind men and the elephant; all were right, in their own way, but you can't see the entire animal until you put all the pieces together.

The Big Money thanks Torben Andersen of Northwestern University, Robert Engle of New York University, and Larry McMillan of McMillan Analysis.