Wall Street Is Complacent and This One Number Is How You Can Tell

An explainer on how the VIX tell us what the markets are collectively thinking

Yet he still won’t give up his iPhone, so there’s that. EMMANUEL DUNAND/AFP/Getty Images

Investors aren’t particularly worried about a downturn in stocks any time soon.

Of course, stating that any of the financial markets are complacent is bound to raise eyebrows for plenty of people besides Elizabeth Warren or Bernie Sanders. But it is a sentiment that, like most things on Wall Street (bonuses, number of homes, lawsuits, and ex-spouses), is almost entirely quantifiable, albeit haphazardly.

There’s one big indicator showing things are hunky-dory from the markets’ perspective. Traders’ favorite measure for complacency is the CBOE Volatility Index, commonly referred to as “the VIX.” It’s sometimes referred to as the “Fear Index” because it is said to rise whenever markets get jittery and fall whenever investors are cheery.

Earlier this week, it reached a 10-year low. Lots of people who write about the markets are talking about the VIX but they don’t really explain it. Perhaps it’s because most financial journalists still confuse the VIX with the company that makes VapoRub.

So what is the VIX? How does it tell us what the markets are collectively thinking? Let’s have a look.

You’re going to do one of these question-and-answer things, aren’t you?


Oh, jeez. Here we go. Let me get something to drink first.

Take your time.

I will since you clearly will, too.

Is that an insult?

Good job knowing how to read into things, genius.

Whatever. Let’s start. What we need to do here is figure out what the VIX is and how it’s determined. From there, we can figure out how the VIX quantifies sentiment in ways surveys or public opinion polls just can’t. And once know that, we can judge if the markets are right or not.

I’m real happy I got that drink.

You’re going to need to catch up because I’m two glasses ahead of you already.

O.K., then. What is this VIX thing?

As the name suggests, the VIX trades on the Chicago Board Options Exchange (CBOE) and it is supposed to give people an idea of how big of a move the market will make in the coming month. It is determined by using prices on a series of options on the S&P 500 (SPX) index.

Hold up. Before you start jabbering any further, why are you talking about the S&P 500? Isn’t the Dow Jones Industrial Average what people mean when they say “the market”?


[Catches breath.]

Sorry about that.

Look, no one in finance takes “the Dow” seriously. If you do that now, please stop doing that because it’s a terrible index for a lot reasons.

The Dow is a collection of only 30 companies chosen in part because they are among the largest and most famous companies in the market. There are about 3,500 companies with stocks trading on U.S. exchanges.

To make matters worse, the Dow is a “price-weighted” index, meaning it’s essentially an average of prices using a weird weightings system to keep it consistent.

Here’s how ridiculous it is: At 7.4 percent, Goldman Sachs has the largest weight in the index. General Electric’s weight is the smallest, at roughly 0.96 percent. In the real world, Goldman Sachs is worth roughly $92 billion while General Electric is worth more than twice as much at $251 billion.

Smart, rational, thoughtful, caring, and better-looking people use the S&P 500 as an index to represent the market. It is comprised of 500 of the largest companies, rather than the Dow’s flimsy 30. And it is weighted by market values (with some adjustment for float) so that larger company moves are larger than smaller company moves. That makes sense, unlike the Dow.

You’re getting off topic.

You just asked about the Dow and the S&P 500.

Whatever. Get back to explaining the VIX.


On their website, the CBOE says that the VIX “measures the market’s expectation of 30-day volatility implicit in the prices of near-term S&P 500 options. VIX is quoted in percentage points, just like the standard deviation of a rate of return, e.g. 23.26. CBOE disseminates the VIX index value continuously during trading hours.”

Thus in this case, they’re pricing it as the percentage rate of return rather than prices.

The CBOE also says the VIX is “a measure of expected volatility calculated as 100 times the square root of the expected 30-day variance (var) of the S&P 500 rate of return.”

Are you kidding me? You’re boring. And why are you using those terms? I fell asleep in high school statistics class.

Who didn’t?

I don’t care. Just break down that definition.

No need to get nasty.

When the CBOE says stuff about “market’s expectations,” they’re using an important equation in the process that says a lot about what people expect will happen to prices in the future. It’s called the Black-Scholes-Merton model (or just “Black-Scholes”). Fischer Black, Myron Scholes, and Robert Merton developed it. Scholes and Merton won the Nobel Prize for Economics in 1997 for their work on it.

Why did they leave out Fischer Black? What did he do wrong?

His only mistake was dying two years before and they don’t award Nobel Prizes to dead people. Funny thing, though: within a year of winning the Nobel Prize, the hedge fund co-founded by Scholes and Merton, Long-Term Capital Management, collapsed after losing $4.5 billion and the Federal Reserve ended up bailing out their investors. It was caused by…

Get back to the topic, please.

So the Black-Scholes-Merton model is used to figure out the price of options. Options are bets that a stock—or bond or commodity or anything else that gets traded—will move either up or down over a period of time. Options give the owner the right (but not obligation) to either buy or else something at a specific price by or at a specific date.

Options can also be thought of as insurance. In fact, when you purchase an option, the payment you make to buy it is called a “premium,” just like when you buy insurance.

What does this have to do with how we know Wall Street is complacent?

Hold on. We’re getting there. First, though, we need to talk about how options are priced because that’s a key to the puzzle.

Ugh! Fine. I’ll ask. How do you price an option?

It depends on a few factors. For instance, the length of time the option is good for before it expires. The longer the time, the more the option costs. Also, interest rates matter. And there’s the option’s “strike price.” If you have an option that gives you the right to sell a stock at a strike price of $70, that option is going to be worth more than one that lets you sell the same stock at $35. If it’s a stock that pays dividends, that’s also baked into the equation.

Oh, and there’s one big factor. And it’s one of the most important elements. In fact, it’s essential to what the VIX is and how we know whether the markets are expecting things to swing wildly or to be chill.

Yeah? What’s that?

Implied volatility.

Remember in the definition above, they mentioned the “square root of variance”? Well that’s also called “standard deviation” or, as financial-types like to say, “volatility.” When an analyst says that market volatility is up, she doesn’t mean it’s getting irate on Twitter and launching missiles or something. Rather, the move in prices, up or down, over a period of time has increased.

So first you have to know the variance. That’s done by first figuring out the average of all the prices over a set period of time, and then summing the squares of the difference between that average and each observation divided by the number of observations minus 1…

This is still so boring. Make it snappier.

O.K., just know that with the standard deviation (the “square root of variance”) of market prices, you can expect those prices to fall in a range between one standard deviation below and one standard deviation above the average price around 68 percent of the time. Around 95 percent of the time, prices will fall between two standard deviations below or two standard deviations above the average. And 99.7 percent of the time, prices will fall between three standard deviations below or above the average.

When the standard deviation (“volatility”) rises, that range widens.

Then why is the VIX defined as “implied” volatility?

Glad you asked. This is where the Black-Scholes-Merton model comes in. All those other factors in their model—time, interest rates, strike price, and dividends—are known.

But one key factor—future volatility—is unknown. And that’s where it gets interesting. You can figure out what the markets expect volatility to be in the future by taking the price where the options are now trading, plugging in the other factors, and then seeing what volatility number would get you to that price.

So that’s the volatility that’s implied by the prices?

Yep, hence “implied volatility.” If the price of the options suddenly shoots up and all the other factors stay the same, the expected volatility is the thing that’s skyrocketing to make the option premiums go up.

Likewise, if the premiums fall, it’s the implied volatility that’s tumbling, all things being equal. It’s plainly obvious in the equation. Have a look:

The Black-Scholes model for pricing call options. That Greek letter is “sigma,” signifying standard deviation, otherwise known as volatility. And, yes, the equation involves square-rooting time without the need of hallucinogens. NobelPrize.org

There was no need for you to post that. Just bring it back to the VIX. Tell me again what it is since your story is long-winded.

The VIX is basically that implied volatility number on S&P 500 options, with some variation that I won’t go into here.

Thank you for not going into how that volatility number is calculated. I can’t believe how terrible you are at explaining this. 

Whatever. You can read about the calculations here.

I’m not going to do that. 

Fine. I’ll make it easy for you. The best way to think of the VIX is that it’s what the markets think volatility will be in the S&P 500 over the coming month.

And it’s down?

Very much so. It’s trading just below 10 right now.

What does that mean?

That means if you took the implied volatility for S&P 500 options expiring over the coming month and annualized that number, it would work out to 10 percent.

That still sounds like a lot.

Consider that the lowest it has ever traded since 1990 is 8.89, that number isn’t so high. If you took an average of every closing price over the past 27 years, you’d get around 19.6. The highest it has ever traded was about 89.53 back in October 2008 at the height of the financial crisis.

You mean to tell me the market was worried about 89.53 percent swing to the downside back during the financial crisis?

Not exactly, but that’s how the options were priced.

That sounds like they were expecting a dystopian future was about to begin.

Kinda, yeah. It was a period of uncertainty, if you recall.

Like, a world where everyone loses hope and crazy people take over. Where socialists, kleptocrats, and game show hosts are leading contenders for president.

I know what you’re doing here. I’m not going down this road.

An America where women walk around wearing red robes and white bonnets.

You’re trying to make me sneak in a reference about The Handmaid’s Tale.

Come on. It’s an easy one and you’ll get tons of clicks, too. Someone on Mic or HuffPo will take a portion of this piece, repost it in another blog post, and slap on a title like, “This Indicator Proved We Were Headed for Trump and Something Out of ‘The Handmaid’s Tale.’ ” 

No, they won’t.

This is what happens when the VIX hits 89. Hulu

What makes you say that?

Because we’re at around 2,000 words already and no one writing for Mic or HuffPo can read a story beyond 150 words. We’re now in a safe space where we can say what we want and no one will repost anything.

O.K., we’re getting off topic again. So when the VIX is high, doesn’t that also mean the market thinks prices can go up that high just as much as it can go down?

You would think that, and that should be the case. But that’s not actually what happens in practice. Instead, the VIX sorta moves opposite of the market. The VIX tends to fall when the markets rise and it tends to rise when the markets fall, thus the nickname “the Fear Index.”

The S&P 500 versus the VIX. They are like mirror images. Data source: CBOE, Yahoo Finance

You used Microsoft Excel to make that chart? You’re so low-brow.


Getting back to the discussion, when the VIX is near all-time lows, it is a signal that the market isn’t expecting to see a drop any time soon.

Why is that?

Because people buy insurance against the S&P 500 falling at almost twice the rate that they buy bets the market will move to the upside. We know this from something called the “put/call ratio.” A “put” is an option that basically serves as insurance against the S&P 500 falling. A “call” is an option that only pays off when the S&P 500 rises above the strike price.

Since 2010, the average daily put/call ratio has been 1.74 on the CBOE. That means that, on average, for every speculative bet that the S&P 500 will go up, there are 1.74 purchases of insurance protecting buyers from the index falling.

That makes sense because if you really believe the S&P 500 is going to go up, you’re probably better off to invest in it more directly like buying the ETF that tracks the index (it trades under the symbol SPY) or else buy futures contracts on the index. On the other hand, if you own the S&P 500 or even a portfolio of stocks, you are more likely to want insurance against it falling. You would buy puts. It’s like buying fire insurance.

I don’t have fire insurance. And soon I won’t have medical insurance.

We’re not going there, either. Again, Mic and HuffPo aren’t reading this far down in the article.

Alright so we know about implied volatility, but what actually happens? Is the VIX a good predictor of future volatility?

Not really. Historically, the VIX exceeds historic volatility 80 percent of the time, according to a study done three years ago by the CBOE. The size of that difference has been an average of 28 percent since 1990. Among other things, it means people are paying too much for the options that insure against a fall in the S&P 500.

Since September 2010, the VIX has traded on average at 17 while the realized one-month volatility for the same time period is 13.25 on an annualized basis.

That’s also a 28 percent premium for the VIX. Doesn’t that mean realized volatility will definitely be around 7.8 percent? Out of my way, Nostradamus. I can predict the future now. Where’s my publicist? I want to be booked on all the financial shows. If Peter Schiff can do it, so can I.

Eh…No. That 28 percent premium is just an average. At any given moment, it can be above or below that number.

Party pooper. O.K, get back to the point. You say the markets appear complacent.

Yes. The VIX is now just below 10. The put/call ratio since Election Day has averaged around 1.5 so investors are buying more puts relative to calls, just not at such an outsized proportion. That said, they are buying both at a rate of 30 percent more than usual during that time period.

However, remember that the last time the VIX was this low, it was February 2007. At the time, the S&P 500 was trading at around 1,455.

And things were awesome after that, right? We’re close to 2,400 now, so that’s like we’re getting a 5 percent annual return over the course of 10 years. This VIX thing is a great indicator!

You really have a terrible case of short-term memory.

What did you say? What were we talking about again?

Anyway, yes, while the VIX was below 10 a decade ago and the S&P 500 is now 1,000 points above where it was then, stocks collapsed in the interim. The stock index plummeted from that 1,400 level in February 2007. By October 2008, around the time when the VIX broke above 89, the S&P 500 fell below 1,000. It hit 666 in March 2009 and it was a rough and rocky road to get back to its previous levels. So a low VIX isn’t always a promise of puppy dogs and unicorns.

This guy has a strong opinion about the S&P 500 hitting 666 in March 2009. Spencer Platt/Getty Images

Why aren’t people worried about a steep drop in the market?

There are quite a number of reasons but one big one may be the fundamentals. Sales and profits for S&P 500 companies are expected to see the best growth they’ve had in five years, according to S&P Global. That projection has been fairly steady for a while. You also have a higher-than-average amount of companies beat their expected earnings in the most recent quarter.

There’s also the fact that the S&P 500 hasn’t moved all that much in recent weeks. The great Alex Rosenberg of CNBC (one of the few financial journalists whom I can guarantee knows how the VIX works) notes that the stock index has moved in the tightest range—just 0.82 percent—over the past couple of weeks than in decades.

And then there’s just the sentiment that Trump and the GOP congress will act more favorably to businesses by offering tax cuts and other things. Reality may or may not bear that out but sentiment is enough for people to be more upbeat on stocks.

What you’re saying is that, in the end, it’s all about feelings?

Pretty much.

That sounds like hippie talk.

Shut up.

Wall Street Is Complacent and This One Number Is How You Can Tell