Volatility ETFs? Think Twice

March 17, 2011

Equity market volatility spiked in response to Japan’s crisis. That makes volatility-ETF buyers winners, right?

Maybe not.

The chart below looks at the last three days of trading (and a bit of today) in the SPDR S&P 500 (NYSEArca: SPY), on the red line. You’ll note that despite some alarming headlines about spreading radioactivity, the hard reality of being a U.S. equity investor during all this chaos has been pretty bland. Despite a 3 percent gap down on Tuesday morning that made many investors gulp, as I write this now, SPY holders are down just 2 percent on the week. Not as good as being up, but still, hardly a “Katie-bar-the-door” scenario.

 

Volatility Intraday: SPY vs. VXX vs VIX

 

What is true is that volatility came back to the market in a big way. The gray line on top of this chart is the VIX. We’ve railed about VIX as a measurement of volatility before—I even dedicated most of a webinar to it—but it’s probably worth repeating. In a nutshell, here’s what VIX actually measures in real time:

  1. It finds the 30-day forward price of the S&P 500 (based on options trading) for the first options contract date that isn’t closer than eight days to expiration.
  2. It then looks at a wide range of strike prices for two strips of options (puts and calls) and weights the premiums investors are willing to pay at those strike prices.

If you really want to get under the hood, you can look at the detailed math. Enjoy.

The formulas used for both figuring out that forward price and then figuring out which options to look at around that forward price aren’t sacrosanct. In fact, they’ve been designed to be easily understood and and calculated, so as to drive CBOE derivatives. Great academic work has been done debunking and improving both calculations (here’s a sample). But the point is that both are rather subjective calls.

So what does VIX really measure? It measures how much people are willing to pay to buy or sell the S&P 500 at dates ranging from eight days from now to almost 60 days from now, at prices well above and well below the current price of the S&P 500. Theoretically, the more people are willing to pay, the more uncertainty exists in the marketplace about where prices are headed.

 

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