VIX: What Is It, What Does It Mean, And How To Use It

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Author: Michael Williams

 

The VIX is a highly touted index on CNBC and in financial circles, but what is it and what does it represent? You may hear it called the “Fear Index”, but that too is a misnomer and not an accurate representation of what it is. Certainly there are times based on the price of this index that it construes fear, but other times it may reflect complacency.

 

What is it?

The VIX is a number derived from the prices of options premium in the S&P 500 index (which is an index comprising 500 large cap stocks).

It is a good indicator of the expectation of market volatility, note I said “expectation”, it is not representative of the actual volatility or what will happen. This is a very important point; it is just a general assumption based on the premiums investors are willing to pay for the right to buy or sell stock.

This premium in options can be loosely defined as risk. Just like other forms of insurance, the greater the risk the higher the premiums, and the lower the risk the lower the premiums. When the options premium fall the VIX falls and when premiums rise the VIX rises. The VIX is not set by any one person, but rather the results of millions of transactions by millions of traders from around the world. The buyers and sellers move the option prices, more buyers and the premiums go up, more sellers and the premiums go down. The VIX takes a weighted average of all these options prices in the S&P 500 index and derives a single number that is called the VIX.

This one VIX number gives us a general idea if investors are paying more or less for the right to buy or sell the S&P 500 index.

S&P500 vs VIX

 

What does the number mean?

For those interested in what the number mathematically represents, here it is in the most simple of terms. The VIX represents the S&P 500 index +/- percentage move, annualized for one standard deviation. Example, if the VIX is currently at 15. That means, based on the option premiums in the S&P 500 index, the S&P is expected to stay with in a +/- 15% range over 1 year, 68% of the time (which represents one standard deviation).

 

Is it high or low?

Historically speaking, the VIX below 20 means that the market is forecasting a rather healthy and low risk environment. However, if the VIX falls too low it reflects complacency and that is dangerous, implying everyone is bullish. Remember the story of the “Shoe Shine Boy”, if everyone is bullish there are no buyers left and the market comes tumbling down.

If the VIX heads higher than 20, then fear is starting to enter into the market and it is forecasting a higher risk environment. If it goes too high, then everyone is singing the “chicken little” song.

Remember the VIX is not set by any one person or even groups of people; it is solely determined by order flow of all buyers and sellers of options. One could extrapolate an equilibrium level, where the market (risk premium) is fairly priced based on the economic landscape.

If we look at historical points of the VIX we see that during the height of the great housing crisis in 2008 and 2009 the VIX rocketed to levels far above 50. Think about that for a second and what that means. For our understanding of the model, the options are pricing that the S&P 500 index (the largest 500 companies) will be in a range of +/- 50% over the year, 68% of the time. At one point the VIX spiked to 85. Those are insane levels that can never be maintained for very long. The VIX quickly came falling back down and then went too far the other way and fell below 15. Again, during the crisis the VIX would have us believe that all is well and that the S&P 500 index has a very low probability of making any radical moves, again the VIX was wrong and it moved back up.

So where is the mean? That is a very good question. I think it depends on two distinct but different factors. First it is the perception of the political and economic climate and second it is the actual fundamental soundness or the math that brings us back to reality. There is perception and mathematical reality and the VIX lies somewhere in between. In my personal opinion and from experience, based on the current geo-political environment I would say the VIX is fairly priced in the 20 point range (+/- 2). However, that mean will change as economic, market, and political conditions change.

 

Is the VIX correct?

I believe the volatility of the VIX is a direct representation of man’s inability to effectively understand risk and price the unknown. The VIX had remained in the low 20s in 2008 when we all knew that problems were quickly spinning out of control, the VIX spiked, correcting its previous assumption. However, it spiked far beyond reality as panic drove option premiums (insurance prices) into the stratosphere. It quickly again over compensated as it fell. The VIX suffered huge whipsaws in 2009, 2010, and 2011 trying to over compensate and find some realm of equilibrium between perception and math.

The VIX has the same human flaw of perception that is found in the equity markets that frequently drive stock prices too high or too low. Human perception can quickly lead to greed or fear, rather than focusing on the math and fundamentals. It is easy to get sucked into the abyss of frenzied social idiocy. Logic, reason, and wisdom are cast aside as we are driven by irrational greed or fear.

 

“Hidden Volatility”

I have a saying known as “Hidden Volatility”; this is when the market premium [options premium] contracts as the equity markets start to consolidate. We know that the market will not consolidate [form a wedge] indefinitely and when it does break out (up or down), it could be a violent move. I equate the term “hidden volatility” to a compressed spring. We cannot see the energy in that spring, but we know it is there and when the energy is finally released it moves fast and violently. How much power is needed and how long that power can last to keep that spring contracted is something that physics can answer; however, in the market that equation is driven by supply and demand. In many cases it is a catalyst event that unleashes the power as one side steps away and forces the other side into full capitulation.

Hidden Volatility happens when volatility in both the equities and options premium contracts. Sometimes in the media they will refer to this as “Greed” or “Complacency”, however what is really happening is that the options premium is below and continuing to decline further than where the mean “should be”. This is subjective, but can certainly be seen and experienced at its extremes.

This is usually a huge warning sign for me that the market will see a rather large and violent correction, usually to the down side.

 

Conclusion

The VIX is a helpful tool and indicator. It gives a current and accurate measure of where options premium in the S&P 500 index is trading. However, it is very important that we understand that the VIX is not right or wrong in its current or forecast measurement of S&P 500 volatility. It is just where the market is willing to trade the premium or current measurement of risk. At the extremes we see that it is wrong and quickly tries to compensate, as buyers quickly become sellers or sellers quickly turn into buyers. It is driven more by the perception and human condition of fear and greed, than by any other force.

Our job as investors, traders, and risk managers is to understand what it is and what it isn’t – to find and estimate a range of accuracy and then determine if human fear or greed is driving it to one extreme or another.

At these tails of extreme there are huge opportunities, for one must see others’ fear or greed as an opportunity and not be sucked in like the rest of the lemmings.

 

Trading the VIX

VIX is both a tradeable cash based options and futures index.

Some VIX options and futures products are: UVXY, VXX, VIIX.

The VIX options and futures can be used to both hedge a long portfolio or even used to take a position in the VIX.

It is important when trading VIX products that one understands its inverse relationship to the equity markets. The VIX will usually rise in value (price) as the stock market (primarily the S&P index) declines.

To hedge a long portfolio one could purchase call options or take a long VIX future position. The general idea is if the long portfolio declines sharply in price the VIX will rise in price and the call options would increase in value. This is a typical hedging method use for large long basket positions.

It is sometimes easier to think of trading VIX options opposite of how you would trade the options in the S&P. If you think the S&P is heading sharply lower then purchasing VIX call options would benefit. If you think the S&P is heading sharply higher then purchasing VIX put options would benefit.

The most frequent problem that new traders have in the VIX markets is understanding its inverse relationship.

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Marking of Sell Orders – By Orders of Singapore Exchange

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Learn how to Profit from Short Selling Singapore Stocks here.

Marking of Sell Orders

From 11 March 2013, SGX will require the marking of sell orders on its securities markets to further enhance transparency of market activities. SGX will publish daily reports on the total value and volume of short sales for each counter the next trading day, based on short sale data collected on the previous trading day. Please also refer to the Guidelines on Short Selling Disclosure issued by the Monetary Authority of Singapore (MAS) on 9 January 2013.

FAQs on Marking of Sell Orders

 A. Information and Rationale

1. What is short selling? 
Short selling in respect of securities is the sale of securities that the seller does not own at the time of the sale, short selling may either be: ‘covered’ or ‘uncovered’ (also referred to as ‘naked’ short selling). In ‘covered’ short selling, at the time of the sale, the seller has borrowed the securities or has otherwise made arrangements to fulfil his obligation to deliver the securities. In ‘uncovered’ or ‘naked’ short selling, at the time of the sale, the seller is not in possession of securities or has not otherwise made arrangements to meet his delivery obligation.

 

2. Is SGX banning short-selling? 
No, SGX is not banning short-selling. SGX recognizes that short selling generally plays an important role in markets as it allows for more efficient pricing of securities and facilitates hedging activities.
However, SGX reminds investors that when they intend to make a short sale, they should have arrangements in place to avoid settlement failures. Penalties will be levied for settlement failures under the CDP Clearing Rules.
Abusive short-selling, such as selling accompanied by false rumours designed to encourage others to sell, may also be construed as intent to deceive or manipulate the market and is an offence under the Securities and Futures Act (“SFA”) and shall be liable on conviction to a fine not exceeding $50,000 or to imprisonment for a term not exceeding 2 years or to both

 

3. What are the new measures on marking of sell orders? 
Marking of sell orders for securities: Brokers may not enter a sell order if the investor has not informed them whether an order is a short sell order (whether covered or uncovered) or a normal sell order. SGX’s Trading Members must put in place systems and procedures to collect such sell order information from investors.
Publication of short selling information: Short selling information on aggregate short sales volume and value for each counter will be published by SGX on its website at the start of each trading day, based on orders marked as short sell executed the previous trading day. Investors can access the report from 11 March 2013.

 

4. Which instruments listed on SGX are subject to the requirement for marking of sell orders?
The requirement to mark Short Sell Orders will apply to all securities traded on SGX, including structured warrants and Exchange Traded Funds (“ETFs”). Extended settlement contracts are not included.

5. Who is subject to the requirement for marking of sell orders? 
All market participants, including investors and SGX-ST Trading Members, must mark their sell orders.
Exemption for Market Makers
Presently, market makers, which include Designated Market Makers and such other entities appointed by SGX to carry out a market making function, are not required to mark sell orders of securities for which they are obliged to market make. This is because they may submit sell orders, where they do not own the security to be sold, as part of their market making function.
The exemption does not extend to Trading Members with facilitation desks that provide liquidity to their clients.

6. When will the new measures be implemented? 
The measures will be effective from 11 March 2013.

7. Will there be more measures governing short selling in future? 
In consultation with the Monetary Authority of Singapore (MAS), SGX will continue to assess the appropriateness of various measures on an on-going basis as part of our responsibility to operate a fair, orderly and transparent marketplace.

B. Published Short Sales Data
8.  Will the published information reveal the names or positions of individual short sellers? 
No. The published information will contain only short selling information on an aggregated short sales volume and value for each counter.

9. Where can I find the published short sales data? 
SGX will publish on its website daily reports on the total value and volume of short sales for each counter by the start of each trading day, based on short sale data collected on the previous trading day. Investors can access the short sales data from 11 March 2013.

10. How accurate is the published short sales data? 
Market participants entering in short trades are expected to accurately disclose the nature of sell orders, i.e. whether they are short selling orders or normal sell orders, as well as the short quantity to be sold.
Market participants should exercise care when interpreting information on short selling. For instance, information on short sale volume may not reflect the outstanding short position in those securities. Volume of short sales may include trades which have since been squared off by offsetting buy trades.

C. Benefits of the New Measures
11. What are the benefits of the new measures? 
Information on short selling activities is relevant to the trading decisions of market participants. For example, information that those securities are under sustained heavy short selling may indicate strong negative price pressure on those securities.
As such, disclosure of short selling activities in Singapore is a step towards enhancing the information available for traders and investors to make informed trading decisions.
Information on short sale transactions also helps to deter market abuse by alerting authorities to activities that may potentially disrupt the orderly functioning of markets, and aids in investigation and enforcement.
Market participants should exercise care when interpreting information on short selling. For instance, information on short sale volume may not reflect the outstanding short position in those securities. Volume of short sales may include trades which have since been squared off by offsetting buy trades.

D. Obligations and Impact on Investors
12. How do the new measures affect me as an investor? 
Brokers may not enter a sell order if the investor has not informed them whether an order is a short sell order (covered or uncovered) or a normal sell order. SGX’s Trading Members must put in place systems and procedures to collect such sell order data from investors.
If and when you call your broker, your broker will ask you whether your sell order is a Short Sell Order or a normal sell order. If you trade through the internet, you will be required to indicate whether your sell order is a Short Sell Order or a normal sell order.
You should approach your broker for assistance with the procedures for marking of sell orders.

E. How to Mark Sell Orders
13. How do I determine whether my sell order is a Short Sell Order or a normal sell order? 
A Short Sell Order is any sell order where the seller does not own the security to be sold at the time of placing the order.
You are deemed to own the security if at the time of placing the order:
a)You are the legal or beneficial owner of the security, unless such ownership is pursuant to a securities borrowing agreement;
b)You:
i) have purchased or have entered into an unconditional contract to purchase the security, but have not yet received delivery of such security;
ii) have tendered other securities for conversion or exchange or have issued irrevocable instructions to convert or exchange other securities into the security, but have not yet received delivery of such security;
iii) have a right or an obligation to purchase the security under an option and such option has been exercised, but have not yet received delivery of such security; or
iv) have a right or warrant to subscribe for the security and such right or warrant has been exercised, but have not yet received delivery of such security; and the delivery referred to in (i) to (iv) would, in the ordinary course, be before the settlement of the sale of the security; or
c) you have lent a security pursuant to a securities lending agreement as a result of which you are no longer the legal or beneficial owner but have a right of recall under the securities lending agreement.
You should approach your broker for assistance if you are uncertain whether your order is a Short Sell Order.

14. I have made arrangements to borrow the securities on Settlement Day. How should I mark my sell order? 
If you have borrowed the security, you should still mark your sell order as a Short Sell Order. An investor is deemed not to own the security if he has borrowed the security to be delivered on or before the settlement of the sale of the security [pursuant to Rule 8A.2.1(a)].

15. I own a partial quantity of the sell order that I intend to submit. How should I mark my sell order? 
You should only mark a sell order as a Short Sell Order if you do not own the full quantity of the sell order. Conversely, you should only regard a sell order as a normal sell order if you have the full quantity of the shares to be sold.
In a situation where you intend to sell more shares than you own, you should enter two separate sell orders. One order is for the portion that you own in full (i.e. normal sell order) and the other for the portion that you do not own (i.e. Short Sell Order).
For example, if you own 2,000 shares and want to enter an order to sell 5,000 shares, you should enter two orders: one normal sell order to sell 2,000 shares, and another Short Sell Order to sell 3,000 shares.

16. I wish to enter into a Direct Business trade. Must I mark my sell order if I do not own the securities that I have sold? 
The requirement to mark short sell orders also applies to Direct Business trades. You must indicate whether your sell order is a Short Sell Order when reporting the trade to the exchange.

17. I have a buy order that is unfilled. I want to enter a sell order. How should I mark my sell order? 
The marking of sell orders should be based on what the investor knows about his positions at the time of order entry.
For example, you hold 5,000 shares of Stock A. You put in an additional buy order for 3,000 shares of Stock A that is unfilled. If you wish to sell 8,000 shares of Stock A, you should enter two orders: one normal sell order to sell 5,000 shares, and another Short Sell Order to sell 3,000 shares. This is because at the point of order entry, the buy order for 3,000 has not been filled.

18. I do not know the quantity of securities that I own. Must I mark my sell orders? 
You must mark your sell orders accurately. For shares which you bought using cash, you can check your holdings through CDP Internet Access or CDP Phone Service.
Please note that outstanding transactions that are due for settlement are not reflected in the holdings. For shares bought with CPF monies, please contact your CPF Investment Bank. Separately, you may wish to keep track of your holdings on an on-going basis so that you are able to mark your sell orders accurately.
To access these self-help services, you will need the Internet PIN or Telephone PIN. To apply, please download the application form from SGX website at www.sgx.com/cdp and post it to CDP. Upon successful verification, we will send the PIN to your mailing address registered with CDP. You may contact CDP at 6535 7511 or cdp@sgx.com if you require any assistance.

F. Modifying Wrongly Marked Sell Orders
19. I have submitted a sell order that I have marked wrongly. Can I modify the order later? 
Orders that are submitted to SGX-ST can only be modified for quantity. If you wish to make any changes in respect of accurate marking of sell orders, you will have to withdraw the order and enter a new order.

20 Will my broker confirm that I have accurately marked my sell orders? 
You are expected to accurately disclose the nature of sell orders. Your broker is unable to confirm that you have accurately marked your sell orders as he does not have full knowledge of your holdings.

21. I have marked my sell orders wrongly and the orders have been executed. Can I modify the order later? Will I be penalized if I do not correct the sell order? 
Yes, you can approach your broker to correct your sell orders if the orders have been executed. Your broker should submit the amendments to SGX on your behalf before 5.45pm on the next trading day. You must inform your broker in advance so that he has sufficient time to prepare the amendments for submission to SGX. You are also expected to accurately correct the quantity of the sell orders.
The accurate disclosure of sell orders is necessary for factual information to be provided to market participants regarding short selling. As such information may be taken into account by investors when making trading decisions, it is important that false or misleading information not be presented.
Section 330(1) of the SFA states that any person who, with intent to deceive, makes or furnishes, or knowingly and wilfully authorises or permits the making or furnishing of, any false or misleading statement or report to a securities exchange, futures exchange, designated clearing house or any officers thereof relating to dealing in securities shall be guilty of an offence and shall be liable on conviction to a fine not exceeding $50,000 or to imprisonment for a term not exceeding 2 years or both.
In applying section 330(1) of the SFA, MAS will consider whether there was intent to deceive in respect of sell orders that had been inaccurately marked by SGX-ST Trading Members or inaccurately disclosed by market participants. As such, if you or your broker is found to have intent to deceive in respect of sell orders, you or your broker will be penalized under section 330(1).
Notwithstanding, as mentioned above, you may notify your broker to correct your sell orders and brokers are required to submit the amendments to SGX before 5.45pm the next trading day.

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