Thursday, January 17, 2013


VIX Hits Pre-Crisis Levels

Yeah, the VIX is getting pretty low.  So low, it might make you worry.  I don't think it should, though, at least not yet.  Here's why.

The VIX is based on option pricing.  A large part of option pricing is based on the volatility of the underlying asset.  The higher the volatility, the higher the value of the option.  So, when investors expect greater volatility in the future, the demand for options increases, and pushes the option price up.  But, the problem is that investors typically don't expect higher volatility in the future unless the market is already more volatile.  So, using the VIX as a measure is almost, well, redundant.  If the market drops, the VIX rises, because investors are reacting to the current volatility and expecting it to get higher.  Of course, then there are other investors who will see the VIX rise and interpret that as increasing volatility in the future and either sell, increasing volatility now, or buy the VIX, increasing the apparent expected volatility.  Either way, it's sort of yet another self-fulfilling prophecy, of which the world of finance has a multitude.

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