Stocks quoted in this article:
Stop watching the CBOE Volatility Index (VIX)! Or said an article on Nasdaq.com a few days ago:
The further removed financial analysis is from the fundamentals, the less likely it is to provide an actual indication as to whether a stock is a good value. Index funds exist at one remove, and options exist at one remove. The VIX is an index of the relative (to what, no one knows) price of options, i.e., the premium, since that is the only part of the price that fluctuates based on market sentiment. This means that it exists at two removes.
The premium in an option fluctuates based on the sentiments of options market makers. If options market makers believe stocks will gyrate wildly in the future, the premiums will be high, and the VIX will be high. That, it turns out, is the most important thing to understand about the VIX, so I'll say it again: the value of the VIX, at any given time, is a forecast as to how volatile options market makers believe stocks will be in the coming months. Right now, the VIX is very low, compared to its historical levels.
You can also trade options on the VIX. To understand how supposed professionals could, when looking at VIX options, completely blow an analysis, it helps to understand that VIX options exist three removes from stock value. An example of such a blown analysis was published just today by Bloomberg. The article examines the ratio of VIX calls to VIX puts, which is four-to-one. That ratio, for those still keeping score, is a number four removes from actual stock values; it is a quadruple derivative, the likes of which your most sadistic calculus teacher would have been ashamed to throw at you.
OK, I didn't love the inferences from that Bloomberg article, either, but this critique is too harsh. It's a valid point that VIX analysis has gotten a little too popular over time, And I'd add that even those of us actually in the options field probably read way too much into every little bit of noise (myself very much included). But it doesn't mean we should stop watching it.
The point he misses, in my humble opinion, is that it's just an indicator of sentiment -- just one piece of the puzzles that may prove helpful on the margins.
Until the end of that clip, he uses the term "remove" here in place of "derivative." And he's certainly right on that count. An index -- the S&P 500 Index (SPX) here -- is a derivative. Options on SPX are a derivative of that. VIX indexes the implied volatility on those derivatives. A VIX future is a derivative of VIX. A VIX option is a derivative of a VIX future. Roll it all together and a VIX option is a derivative of a derivative (VIX future) that's a derivative of a calculation (VIX) which proxies the implied volatility of options on a derivative (SPX).
So yes, we've gone very far out on this chain. It's like a math-y game of Telephone.
But there's nothing wrong with trying to read something into the trading action on parts of that chain. It's just important to recognize a few points.
Sample size is generally low. Twitter is filled with "Indicator X looked just like this in 2007, hence we're going to meltdown" sorts of analysis. Coincidence too often implies causality.
The context of the dollars committed to a "bet" is often lost as well. A month barely goes by without hearing about someone buying 10,000 out-of-the-money VIX calls, or $2 million of VIX calls, or whatever. Is he just hedging a portfolio? Is he running $10 billion and this is just a tiny play? Is this the 28th month in a row the same player has bet on a VIX explosion that rarely happens? I could go on.
And finally, and to me most importantly, what's the actual meaning when VIX pops or sentiment on VIX futures and options changes? As I often note, I find it a contrarian tell. The more that believe VIX is going to pop and the more money they place on that bet, the less likely it is to actually happen. At least, that's my view; others look at it the other way.
But whatever -- the larger point is we shouldn't stop watching the VIX entirely. It's never gospel, and it often just confirms something we already know, but there's often some good info there if you take in the entire picture.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.