In the aftermath of the recent market correction, there is a lot of news about the VIX, popularly known as the market’s “fear gauge.” I update the VIX along with actual market volatility each week in my WTWA series. Let’s take a deeper look at this much-misunderstood indicator.

VIX Misconceptions

It is helpful to start by addressing the misconceptions.

The Basic Facts

Historical volatility is a mathematical calculation based upon past data. Many people use the term without knowing how to do this calculation.

The value of options (equity and others) is based upon five factors identified by Fischer Black and Myron Scholes, who won the Nobel Prize in Economics for their work. (There have been some modifications in methods since then, but this is good enough for our current purposes). Fischer Black and Myron Scholes:

One of the attractive features of the Black–Scholes model is that the parameters in the model other than the volatility (the time to maturity, the strike, the risk-free interest rate, and the current underlying price) are unequivocally observable. All other things being equal, an option’s theoretical value is a monotonic increasing function of implied volatility.

If there were no volatility – no expected change in prices – options would have no value – zero. If you take the trading price of an option and apply the four known factors, you can learn the level of volatility implied by the price. This usually has some relationship to the historical volatility, but sometimes does not. An impending earnings report, the results of a court case, or the outcome of a drug trial are all examples of situations where expected volatility would be much higher than historical values.