How This New "Fear Gauge" Could Fix the VIX

Volatility has gripped the markets for much of 2016, with wild up-and-down swings roiling markets and giving way to fear (and near-panic) among investors.

If you follow the stock market, you know what the VIX is. It's the volatility index. It's also known as the "fear index" or "fear gauge" because increased volatility is almost always accompanied by a surge of fear.

But here's something you may not know: the VIX is about to face some competition - and with good reason.

Yesterday, Bats Global Markets, the second-largest exchange operator in the United States, and T3 Index, an Australian developer of index products, introduced their own version of the fear gauge with the announcement of their Spikes (SPYIX) product.

Today, I want to take a closer look at what traders mean when they talk about volatility, show you exactly what the VIX is and what it does (and doesn't do), and tell you why now is the perfect time for a new, more modern approach to how we track volatility.

Let's get to it...

How Traders Track Volatility

magnifyThe VIX is an index. It's an indicator of expected volatility in the market. It's actually an index of implied volatility, derived from other measures of implied volatility.

Implied volatility is important to understand, because once you understand what it is, you'll understand what the VIX really is and what the new SPYIX fear gauge really is.

Back in 1973 Fischer Black and Myron Scholes introduced the world to their options pricing equation, known as the Black-Scholes model. The model gave investors a way to calculate theoretical values of options and launched the financial options industry.

One of the pieces of the options pricing model is a measure of volatility.

If you're going to buy an equity option from someone, you want to know how long you'll have the right to exercise that option and how much the underlying stock will move up or down.

That movement up or down of the underlying stock is measured as volatility.

The Black-Scholes model uses historical volatility of the underlying stock in its equation. When calculated, the model generates a theoretical value of an option.

But in the real world, the equation derived value of an option isn't always the price at which an option trades.

In fact, more often than not, the price of an option in the real world is quite different than its model-derived theoretical value.

Changing How We Think About Volatility

Back in 1983, when I was a market-maker on the Chicago Board Options Exchange, I knew prices in the pits weren't what the Black-Scholes model said they should be.

So I got together with a few colleagues and tried to figure out why. We determined that the price of options in the real world reflected what investors and traders thought the actual volatility of the underlying stock was, not what a mathematical measure of its historical volatility was.

The measure of that volatility (it can be measured) isn't historical, it's implied.

Implied volatility is what the market (that's buyers and sellers) thinks it is.

The VIX is an implied volatility index. It's derived from options on the S&P 500 Index.

All the put and call options that trade based on the S&P 500 Index all have different prices, and all of those prices have their own implied volatility components. The VIX looks at the prices of puts and calls 30 days out on the S&P 500 and extracts the implied volatility (what buyers and sellers think volatility will be) out of all those options, creating an index of implied volatility - what investors buying and selling puts and calls on the S&P 500 expect volatility to be.

If the VIX is at 15, that means the market thinks the S&P 500 can move 15% up or down over the next year. If the VIX is at 40, that means buyers and sellers of S&P 500 Index options think the S&P 500 can move up or down 40% in the next year.

The higher the VIX, the more afraid investors become. That's because the market is telling the world, if the VIX is at 40, there's a chance the market could go up or down 40%, which is a scary move if it's to the downside.

The fear factor is the overriding emotion because rising volatility almost always points to selling pressure rather than increased buying.

A New Measure of Fear

Bats' new fear gauge isn't too different from the VIX - but there are some key differences that could make it a much more reliable measure of implied volatility in today's markets.

Instead of calculating the implied volatility inherent in puts and calls traded on the actual S&P 500, Bats calculates the implied volatility on puts and calls that trade on the SPDR S&P 500 ETF (NYSE Arca: SPY).

SPY is an exchange-traded fund (ETF) that tracks the S&P 500. It isn't the index, though it trades just like it.

In fact, SPY is the most-traded security almost every day. It's been averaging over $24 billion in notional value of trading per day since mid-2015. And options based on the SPY account for almost half the $110 billion notional value of all options traded daily in the United States.

Bats says that options traded at the CBOE based on the S&P 500 Index are still traded "manually," while options that trade on the SPY are traded on electronic exchanges, which makes their new Spikes volatility index better because it's updated far more quickly.

And they point to the problems the VIX had back on Aug. 24, 2015, when options market-makers and traders of S&P 500 options in Chicago weren't trading fluidly. Wild swings in the market caused a delay in pricing that triggered a breakdown in the VIX.

Meanwhile, electronically-traded options based on the SPY continued to trade smoothly on the same day.

As Bats Executive Vice President Tony Barchetto said, "In the wake of recent events, the SPYIX is Bats' response to the market's demand for a more rigorous and dependable volatility gauge. SPYIX is specifically designed to better capture and reflect today's largely electronic options market."

There's no doubt that 2016 will continue to be a volatile year in the markets - I've been saying as much since last year. And there's no telling when the next bout of extreme volatility might cause another breakdown in the VIX.

So now is the perfect time for what could be a more precise, reliable measurement of implied volatility.

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But because the two fear indexes are so similar, it will be the market itself that decides which one will be more popular. While Bats is definitely on to something with SPYIX, it's going to be hard to knock the VIX off its throne as the go-to fear gauge.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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