Q & A. Why Does VIX Follow Market Direction?

Hi Mark,

Hi have a question about the VIX. Why is it that VIX increases and decreases more or less with the market rather than with the market's volatility?

For example, yesterday the market was significantly down, and VIX shot up. Today, the market was significantly up. Not quite as much as it went down yesterday, but VIX almost returned to where it started? Why are option sellers less concerned about upwards volatility than downwards volatility?

Thanks.

— Russ

Markets tend to fall much faster than they rise.  That is not necessarily going to continue forever, but when it comes to trading options, perception is everything.

Thus, it's not the market's direction, in and of itself, that drives volatility, it's the actions of the people who buy and sell those options.

With the banks once again making major negative headlines, there was a real fear that the end of the world was at hand.  In those situations, option buyers dominate the activity.  Portfolio protection was needed.  Speculators wanted to buy puts. Investors panicked.

Under those conditions, market makers who are selling those options raise the bids and offers for all options.  When the buying stampede continues, prices rise again.  This is a very fair and ethical behavior.  If people are buying all you have to sell at one price and continue to bid for more, it's foolish to maintain the price and get run over.  Raising prices in the face of demand is well understood in the stock market, and everyone must understand that's it's just as reasonable when trading options.  Supply and demand play a role in the pricing of options.  When fear of a debacle is in the air, price is not a concern and those who feel they 'must' own options pay any price to get them.

When markets rise, those fears are alleviated.  Whether this is reasonable or not, is not the issue.  The point is that call buyers are more patient and don't feel the need to panic.  Few fear missing an immediate market surge and thus, there are many fewer people who 'need' to buy options right this moment.

With options at 'elevated' levels and with few buyers, the sellers predominate.  It's not that they are anxious to force prices lower, but when there are more sellers than buyers, the market makers slowly but continuously drop the volatility number they use to calculate the value of the options they trade.  With lower theoretical values for the options, the computers that generate the bid/ask prices produce lower bids and offers.  Thus continues as long as there are far more sellers than buyers.  It also occurs when market makers are anxious to sell options – believing the panic is over.

But keep in mind that the blind sale of options is risky business and in today's world, there are very few, if any, professional traders who want to accumulate big risk.  Most hedge their option trades as quickly as possible.  Nevertheless, when the markets rise, fear of a disaster goes away and option buyers are buying patiently, or not buying at all.

This doesn't continue forever.  At some point the sellers disappear and prices level.

But it's fear of getting clobbered – and the corresponding rush to buy puts – that drives implied volatility (and VIX measures that) of the options.  And it's not just puts – call prices must rise also (to prevent arbitrage opportunities.

Addendum (9:16 AM)

Note that in today's selloff, RUT is lower by 12 points and RVX (the 'VIX" of RUT options) is higher by less than 3 points.  Over the previous two days, it rose by 12 and fell by 9.  Thus, today there's no panic put buying (at least not yet).  The idea may be that 'we've seen these RUT levels recently and we're not too afraid that it will go much lower.

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2 Responses to Q & A. Why Does VIX Follow Market Direction?

  1. Russ Abbott 01/22/2009 at 11:58 AM #

    A question on a separate matter. When I enter an order that is between the bid and asked is that order visible across the country so that someone can respond to it? Or must I wait until the market maker responds.
    Also, what happens with spread or iron condor orders? Is there any way for them to be public so that someone other than the market maker can take the other side?
    Basically, I’m asking about the order processing mechanism and the extent to which the public can participate directly rather than having to go through a market maker.

  2. Mark Wolfinger 01/22/2009 at 12:20 PM #

    This is a question for your broker, but I can tell you what is supposed to happen.
    When you enter an order for a single option that order is displayed so everyone can see it.
    Sometimes your order does not stand alone because others are now willing to trade at your price. For example, if you see .90 bid and 1.20 offered and you try to sell 10 @ 1.10, you may see many more than your 10-lots offered at 1.10 – but the 1.10 offer will be shown. If it is not so displayed, tell your broker that you insist they find a way to display that bid or offer.
    My broker displays my bids and offers for COMBO or spread orders. The problem is, I have no idea who can see those bids/offers.
    But I can tell you this – unless the customer is trying to see that specific spread, there is no way he/she will see it. Thus, the public should be able to see your offer, if they look for it – but you must ask your broker if they make any effort to display your orders. If they do, you can ask further questions to try to learn more.