Don Worden on the VIX

Some timely comments on the VIX from last night’s Worden Report:

The Worden Report (Wednesday, July 21, 2004)


I have been getting a lot of inquiries about the VIX and what role it is playing in the present situation. The following is excerpted from an article I wrote in this report in September 2001. (The symbol for the CBOE Market Volatility Index is VIX–X.)

The conventional belief on Wall Street is that the VIX is a sentiment indicator, which I disagree with. In fact, it is not even a volatility indicator. Actually, it is a measure of whether the OEX options are selling above or below their fair values (as generally estimated by the Black-Scholes formula). The formula embodies three elements: 1) prevailing interest rates 2) time to expiration 3) implied volatility as measured by dividing the current price by the 12-month high minus low (along with the price and strike price, of course). This produces a specific answer that we call the estimated fair value. In real life the option may at any time be selling above or below the estimated fair value.

These variations are generally blamed on embodying excessively high or low volatility in the formula, although it would be just as easy to say for some reason the formula embodies an exaggerated interest rate level or an incorrect time to expiration. When the time premium goes up, the jargon on the street says the implied volatility is up. Which isn’t true. The volatility is what it is. But a different number is put into the formula. When the VIX goes up, it is not a sign that market volatility is up. It is a sign that options are selling at higher premiums.

Empirically, we can see that the premiums on OEX options go up when the market goes down. And vice versa. However, it is not obvious to me why this happens. Higher priced options don’t tell me anything about fear. Lower priced options don’t tell me anything about greed. However, whatever the underlying reasons, the VIX is a contrary indicator. But keep in mind that the Dow turned upside down is also a contrary indicator. The VIX more often than not looks like the Dow turned upside down.

Personally, I don’t think the VIX has any value except at important capitulatory bottoms, and even then it is only a confirmatory value. It may be that that is the kind of bottom we’re heading for. The chances are good that the VIX will rise to a peak at the coming bottom, whenever and wherever that may be. I don’t think we’ll see anything comparable to those peaks we saw in the third and fourth quarters of 2002, because those marked the bottom of a primary bear market. What we are looking for now is a bottom to an Intermediate Downtrend.

My working targets for the Dow, the SP-500 and the Nasdaq Composite remain 9000, 975 and 1500. -DW


  1. Posted by tom on July 22, 2004 at 3:09 pm

    I agree the Vix’s primary value is as a confirming indicator — in combination w/other readings it can be useful… thing is, the raw number means nothing.

    This year, though, vix bottoms *have* coincided with market tops, and vix tops *have* coincided with bottoms… what I look for is large breaks in one direction or the other, and large spikes above/below the moving average — these generally (70 percent is the number I’ve seen quoted) hint at an approaching market reversal.

    Where people go awry is betting on the reversal before it actually happens. My understanding of money management is that you might dip your toe in the market if you think the reversal is near, but you wait till the new trend is confirmed before you throw real money at it.

  2. Posted by Duru on July 25, 2004 at 4:27 pm

    Worden’s point is a great reminder that the VIX is just a proxy – and an approximate one at that. It seems that during this sell-off people are choosing liquidation as portfolio insurance and protection rather than put-buying… It would be interesting to break this open a bit and look at whether absolute put and call volumes are changing at all.


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