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On the Zero Predictive Capacity of VIX

VIX is a derivative of price and no derivative of price can predict price. VIX is a non-linear 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.


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