"RELIVES psychic distress?!" How's that for an ironic typo...
“RELIVES psychic distress?!” How’s that for an ironic typo…

Two posts:

  1. All The Fuss About Financial Stress Levels (involving end-of-the-world predictions and some reasonable alternative interpretations).
  2. All The Fuss About Volatility (involving Latina shares and the up-and-down search for companionship).

To summarise:

  1. People panic about the world.
  2. Some people panic by looking at the St Louis Fed Financial Stress index (I know – seems a strange way to panic).
  3. That particular index is made up of interest rates and the VIX.
  4. When you talk about the VIX, you’re talking about volatility (and we’ll get back to this in just a moment few paragraphs).
  5. People are concerned by this: Screen Shot 2014-06-26 at 7.00.28 AM
  6. And this:Screen Shot 2014-07-03 at 8.39.39 AM
  7. Because see how the current VIX and SLFFSI levels look a lot like the levels that we saw just before the 2007/2008 financial crisis?
  8. Well, history repeats itself.
  9. Therefore, the end of the world cometh.

Now this is a particularly confusing interpretation (at least, to me). Because firstly, if you’re taking cues from that Financial Stress Index, then I’d be saying, in my best sarcastic voice:

You’re absolutely right. Those low interest rates that caused those low readings in the index are 100% driven by everyone being all “Bring me my risk – you don’t even have to pay me for it!” and not at all caused by the Federal Reserve engaging in many years of Quantitative Easing in order to LOWER INTEREST RATES*.
*I gave a less sarcastic explanation in that financial stress levels post, if you’re interested. 

And if you’re looking at the VIX… Well that’s where volatility comes in.

What is the VIX?

So “volatility” is a measure of how hyperactive a share price/bond price/anything’s price is over time. And we mostly use it when pricing an option (that is, a right to buy or sell something in the future). The daily-life example:

  1. You own a car.
  2. You take out insurance.
  3. What are you doing when you pay your insurance premiums?
  4. At its core, you are buying the right to sell the car to your insurer at some future point in time, at its replacement market value, if the car is written off (ie. worth nothing).
  5. The more of a risk you are, the higher your premiums.
  6. The less of a risk you are, the lower your premiums.

Options are basically a form of share/bond/asset insurance.

Of course, in the real world, you don’t observe “risk” directly (its quantity is floating somewhere in the future). But commerce has never yet let reality get in the way of a profit, so that hasn’t stopped us from having insurance.

What this means in the world of stock exchanges:

  1. We know what share prices are (they’re quoted every 15 minutes on Yahoo Finance); and
  2. We know how much share options are (they’re also quoted).
  3. In theory, a share option’s price is calculated by taking the current share price and the terms of its contract (timing, etc), and then throwing in a measure of the share’s volatility.
  4. So because we know the share price and the option price (and the terms of the contract), we can do a reverse calculation to get the “implied volatility” (the volatility implied by the combination of those two prices). Or a computer can do it for us.

Some would throw in a Black-Scholes-Merton formula at this point, but I don’t think it’s particularly important. All anyone really needs to know is that I could take the price of my car, and the cost of my insurance premiums, and get a rough idea of just how risky I am (according to my insurer). And we can do the same thing with shares.

And the VIX does it for you – it is an index of the “implied volatility” calculated using 30 day options taken out on movements in the S&P 500 index.

In real world terms: it’s a rough idea of how much market movement investors are expecting to see over the next 30 days.

Some helpful rules of thumb:

  1. A VIX number of 0 means that there will be no movement in the market at all in the next 30 days (which would indicate that the world had actually ended, because the market would be no longer).
  2. A VIX number of 100 means that the market will move by an (annualised) 100% in the next month.
  3. The higher the VIX gets, the more likely that the world might actually be ending for real in the next month (followed by a VIX of 0 in month 2).
  4. In 2008, the VIX hit the 80 mark (a wow moment if ever there was one).

Here’s the concern

The concern is that a really low VIX number (floating below the 20 mark for the last year or so) means that the market is “complacent” and/or underestimating the levels of risk that are floating around.

And that’s the type of attitude that gets you asset-pricing bubbles.

So here’s my observation:

  1. The implied volatility could be low because people are feeling complacent about risk (that’s the end of the world scenario).
  2. Or it could be low because people aren’t really all that keen on 30 day options (ie. investors want longer term options, because people are expecting the recovery to reflect in the future).

And to be honest, who really expects a great US recovery within the month?

PS: for an awesome article on the VIX, read this one by Matt Levine.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.