When we introduce aspiring option traders to the various pricing factors that determine the value of an option contract we often use an insurance analogy to describe implied volatility. The short version of the story is that implied volatility is the pricing factor that is closely associated with the risk of price movement in the underlying market. We expand on this idea using the idea of the cost of homeowner’s insurance as a hurricane is bearing down on south Florida. If a homeowner has forgotten to renew their homeowner’s insurance they are going to find the policy cost as a hurricane is approaching their home much higher than during a period of calm weather. This increased cost is a function of higher risk of the home being destroyed in the near future. Stock option prices usually move higher in front of anticipate price moving events such as a new product announcement or earnings report. This increase in the option premium is associated with higher implied volatility much like the higher insurance policy premium is a function of higher risk for policy seller.
VIX is a consistent measure of 30 day implied volatility as indicated by S&P 500 Index (SPX) option pricing. VIX has moved in the opposite direction of the S&P 500 about 80% of trading days over the past few years. A very common question is, “why do VIX and the S&P 500 move in opposite directions?” I’ve been thinking of ways to describe the ‘why’ behind this behavior in relation to the insurance analogy we use with respect to implied volatility.
With the description of higher implied volatility in relation to the cost of a homeowner’s policy the participants in the contract know a hurricane is on the way. That’s why the insurance company would charge more for the homeowner’s policy and the unhappy homeowner would expect to pay up for protection. We also tend to have a good idea of pending events that will move an individual stock price. With the overall stock market it is not as easy to anticipate events that will move the markets.
Think of the reaction of VIX as if there were no way to forecast the weather other than what the weather is doing at the current moment. Before a hurricane hits there is usually heavy rain and a thunderstorm. Without a forecast of what is next, people living in south Florida may over prepare each time there is a bad storm. If all they have to judge that a hurricane is on the way is the current weather there is no way of knowing if this the time the storm is the beginning of something worse.
In the financial markets when the S&P 500 shows some weakness portfolio managers may be uncertain if even a minor sell off is the beginning of a bigger move to the downside. Based on this concern managers often seek portfolio protection through purchasing S&P 500 put options. This increased demand results in higher implied volatility as indicated by higher SPX option premiums. This translates into higher VIX. On the other side of the equation, when the markets are moving higher or are a little stagnant, managers may not be as aggressive when seeking portfolio protection which would translate into VIX moving down.