Stock Volatility Is Down. But Is That Good News?

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M. Spencer Green / AP

Traders work in the Volatility Index pit at the Chicago Board Options Exchange

Is the market recovery built on a good foundation, or are we looking at a house of cards? One clue lies in the Chicago Board Options Exchange Volatility Index, more commonly known as the VIX.

The VIX gauges the options market's expectations of the 30-day volatility of the S&P 500 index. While the VIX has fallen from a high of over 80 last year to a new low under 23, it is still above its historical average of around 20. Eight years ago, after 9/11, it spiked to just over 40. Recently, stocks have reached new highs for the year, so a move down in the VIX is certainly reasonable.

But is the low VIX a loaded spring ready to uncoil upon another bit of bad news, or is the investor-anxiety balloon finally deflating?

Traditionally, the VIX has been described as a "fear index": the higher the index, the greater the pessimism as investors fear market instability. Technically, it is a barometer of implied volatility over the next month, specifically calculated from options prices over the S&P 500's underlying stocks. Bearish put options, the right to sell a stock at a specified price in the future, generally dominate a high VIX.

Volatility is almost universally misunderstood: that one number can imply any number of market conditions, all of which mean different things to different investors. That's because volatility assumes stocks prices move in a certain way, but this model is limited and unrealistic. Put options are used to hedge against big downward swings in prices, which are a very specific face of high volatility.

Forget volatility. The VIX is a measure of the price of insurance against market instability. After all, put options essentially insure against market declines.

Traders writing (i.e., selling) put options are, therefore, the insurers. But why should their opinions affect the most (mis)quoted measure of volatility, the VIX? Many justify using options pricing because options traders are supposedly more sophisticated investors; options are considered more complex than their underlying stocks. But these are the same "sophisticated" investors who suffered enormous losses over mortgage-based securities. Can we really trust an index derived from their (mis)pricings?

Before the crash, from 2003 to 2007, the VIX was well below its historical average, chilling in the 10 to 15 range. In hindsight, insurers charged dangerously low premiums against catastrophe. Let's hope we're not heading there again.

Put-options prices have fallen either because there is less demand for them, or perhaps due to oversupply as the market has been saturated by financial firms wishing to sell these options. The VIX may have continued its descent because investors do not fear a market crash enough to buy insurance at the same premium. Or perhaps more banks are writing options — selling insurance on a possible market crash.

Either way, if there was an extended downward move in equity prices, those who did not buy insurance would be in some trouble, but those who sold insurance too low would be in even greater financial peril.

Options are not like other insurance policies — say health insurance. Stocks tend to move together, whereas one person's health tends to vary independent of the nation's health. Risk to health-insurance companies decreases as the number of policies increases; risk compounds for options writers as their volume increases. Those writing put options have secured small gains for now, but they will suffer multiplied losses across the board should the market tank.

Since stocks are pushing higher, the VIX has obviously come down partially as a result of an easing of fear among investors. But these investors have not forgotten their fear, and it could easily escalate.

In this precarious recovery it might take only one tremor to knock loose the foundations of this market rally, and in that sense it may well be a house of cards. The fact that insurance against that risk has gotten quite cheap should not lull us into thinking that the risk isn't there.

On this anniversary of 9/11, it's worth reflecting on the nature of risk. To wit, were Americans more at risk on Sept. 10, 2001, when everyone felt quite safe, or on Sept. 12, when everyone felt threatened? Our perception of risk, and the reality, can often be quite different.

Bottom line: the price of insurance is not a great predictor. So enjoy the improved stock-market performance but don't put too much faith in the market's next moves just because the VIX is saying all is well.

Officer, a regular contributor to, is director of automated trading and analytics at Traditum LLC, a Chicago-based proprietary trading firm.