What can VIX predict? Basically, nothing. This is simply because it is a derivative of price and no derivative of price can predict price. So what is VIX to deserve thousands of articles in just a couple of days in major financial news media? It is apparently another bogey the media is trying, unintentionally in my opinion, to turn into another self-fulfilling prophecy. To make a long story short and as I will demonstrate in this blog, VIX is simply a function of the inverse of the price of a security. When prices rise, VIX falls and when prices fall, VIX rises, basically this is what happens with a few minor twists.
According to Wikipedia:
The VIX is calculated as the square root of the par variance swap rate for a 30 day term initiated today. Note that the VIX is the volatility of a variance swap and not that of a volatility swap (volatility being the square root of variance, or standard deviation). A variance swap can be perfectly statically replicated through vanilla puts and calls whereas a volatility swap requires dynamic hedging. The VIX is the square-root of the risk neutral expectation of the S&P 500 variance over the next 30 calendar days. The VIX is quoted as an annualized standard deviation.
Now, if the above sounds like Mandarin to you, there is a better way. This is the common sense way, unfortunately the way under attack in this society:
On the daily S&P 500 chart of daily closing prices, the top indicator pane is the VIX. The middle indicator pane is the inverse of the S&P 500 price times 20,000 and the bottom pane the Average True Range of the last 14 days. What do you see?
I see very few differences in terms of overall behavior. All three have basically the same behavior with respect to price action. There is a difference at the 2009 bottom when the VIX and the ATR(14) have already made a top but the inverse of price naturally is at a maximum. Otherwise, the same behavior. Basically, for all practical purposes, the Mandarin above can be translated to a “simpler” statement of the form:
VIX = k(P)/P
meaning that the VIX is a function of the inverse of price P multiplied by a constant k that is – in general- a function of price. Does this have any predictive capacity? Absolutely none. Can such predictive capacity be enforced by the financial media? Probably yes, unless rationality prevails over stupidity.
Disclosure: no relevant position at the time of this post.