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Practical applications
Should an alert trader/investor sell options (and hedge) when the VIX (or VXN) rises? If the rise in the VIX reflects mainly investor fear, then the sale of options is potentially profitable. If, however, the rise in the VIX reflects an increase in anticipated volatility, then such selling of options is not potentially profitable.
The authors' research indicates that prior to August 1998, the VIX reflected fear and potential profits existed. Thereafter, however, neither the VIX nor the VXN seem to have reflected fear. Therefore, selling options when the VIX and VXN rise does not appear to be a profitable strategy.
Abstract
This paper examines the behaviour of the 'VXO', previously called the 'VIX', and 'VXN' measures of the volatility implied by stock index options. From the mid-1990s to the end of 2002, the volatility measures seem to reflect both sentiment associated with market declines ('fear') and imminent actual volatility. There is a stark difference between the early and late parts of that time interval, however. Prior to the Russian default in August 1998, the volatility measures do not forecast imminent stock index volatility; the VXO in this early period seems to be reflective of investor fear. In the interval after the Russian default, however, both the VXO and the VXN reflect future volatility rather than investor fear.
INTRODUCTION
The VIX, the implied volatility of 30-day options on the S&P, has gained popularity as an indicator of investor fearfulness about future declines in stock prices.1 Some market participants claim that, when stocks prices decline, investors become afraid of holding stocks, and their fears are reflected in a higher VIX. Indeed, it has become common for financial commentators to refer to the VIX as the 'fear gauge'. An alternative viewpoint, rooted in the theory of options, is that the VIX forecasts the imminent volatility in the S&P.
Whether or not the VIX is a fear gauge has implications for market efficiency and for whether certain types of trading strategies involving options on stock indexes are profitable. For example, if investor fear raises option premiums, there might be profitable opportunities to sell index options (and hedge them) at such times. In contrast, if expected volatility is raising option premiums, and if volatility does...