Volatility indexes

CFA Level III Portfolio Management
#1

Hi everyone, would like to get help on the following

Text

Volatility indexes: These indicate the level of fear in the market. It can be calculated using the bid-ask spread on index options. It increases with more purchases of puts and decreases with more purchase of calls.

My question

  1. Am I right to assume that the “it” refers to the bid-ask spread?

  2. If so, can someone please explain why does the bid-ask spread increases with more put buys and decreases with call buys?

Thank you

#2

“It” means the volatility index.

#3

Thank you.

But may I know why the volatility index increases with more put buys? If people buy more puts, then doesn’t that mean they expect the index to fall? However, the text above indicates that it should increase.

#4

Investor fear, more puts = scared of the market falling. More calls = believe the market will rise (less fear).

The index measures fear, i.e. more puts = more fear = higher index.

#5

Thanks that is what I initially thought so too. But if you think about it, if investors are fearful, then the volatility index should up to signal they are fearful. If so, then the right thing to do to profit from this uptrend would be to long call?

#6

The volatility index increasing does not mean that asset prices are increasing, i.e. does not mean that a call is likely to be in the money in the future.

Volatility indexes are a way to gauge market sentiment, as with short interest or purchases on margin. If the index is high, sentiment is that the market will decrease. As with short interest, the greater number of short sales in the market, the more investors are bearish (can be a bullish sign though when short interest in the market is very high). Purchases on margin push asset prices up and tend to be a bullish signal from investors (similarly though when the market hits a certain level of purchases on margin it can be a bearish signal, i.e. contrarian viewpoints).

I think the confusion here is that the index is not tracking asset prices, its gauging fear based on the purchases of calls and puts. As more puts are purchased, it’s a bearish sign, and investor fear is high, making the index measuring the investor fear increase, not asset prices.

These tools are used in discretionary tactical asset allocation to get a feel for where the managers believe they can add value.

#7

Thanks for following up with a reply. If reference were to be made to the underlying asset, then I can understand that ie. if investors feel price would decline, then they buy puts. But the text mentions “It can be calculated using the bid-ask spread on index options”. Has this statement got anything to do with what you are explaining or this a separate point entirely?

Thank you.

#8

The volatility index is based on a weighted average prices of OTM calls and puts (implied vol is derived) on an index (eg. S&P500). If more puts are bought, people are fearful -> volatility index will go up because they expect the S&P to fall.