Options Volatility: The VIX, Rule of 16, and Skew

Modern investors get frequent updates on the latest readings from the Cboe Volatility Index^® (VIX).¹ Some even refer to the VIX as the "fear index" because it typically rises when the broader stock market falls.

In fact, advanced traders can even trade futures and options on the VIX. But for all the attention it gets, few investors really understand this measure of options volatility, what it means, how to measure it, and finally, how to estimate its most accurate value. Let's take a closer look at the indicator and two related volatility metrics—the rule of 16 and volatility skew.

The Cboe^® introduced the VIX in 1993 as a weighted measure of the implied volatility (IV)² of S&P 100^® index (OEX) options. The more actively traded S&P 500^® index (SPX) options replaced OEX options in the calculation of the VIX in 2003. Since its inception, the VIX has evolved into the preeminent measure of investor fear and overall market volatility.

As investors monitor the VIX on a daily and weekly basis, they're simply watching a number that represents the IV of SPX options. Without getting into a long math discussion involving square roots, let's simplify an interesting aspect of the VIX, which is the number 16 (or more precisely, 15.87). It's the square root of 252 (the number of trading days in a year). Rounding 15.87 to 16 is where the rule of 16 gets its name.

Let's walk through some hypotheticals. According to the rule of 16, if the VIX is trading at 16, then the SPX is estimated to see average daily moves up or down of 1% (because 16/16 = 1). If the VIX is at 24, the daily moves might be around 1.5%, and at 32, the rule of 16 says the SPX might see 2% daily moves.

The options rule of 16 works the other way, too—you can "annualize" a daily reading by multiplying it by 16. For example, suppose a stock has had a few moves of 1.8%, and you think a 1.8% daily move might accurately capture the stock's inherent volatility. If so, you'd be expecting an annualized volatility level of 1.8 x 16 = 28.8%. Because volatility is an important variable of options pricing models, comparing your expectation for an underlying security's volatility to the current IV might indicate whether you believe an option is overpriced, underpriced, or fairly priced.

Now that we've discussed the rule of 16, let's tackle options skew³. Skew can show up across different strike prices or different expirations (or both). For example, in the index market, it's not unusual to see an out-of-the-money⁴ (OTM) put IV at a higher level than an equivalent OTM call IV, causing higher premiums on the put side. This type of skew is sometimes attributed to higher demand for portfolio protection (index puts) from large institutional investors during times of uncertainty and comes from the perception that stocks fall faster than they rise.

• Time skew: When options on the same underlying security have notably different IV across different expirations.
• Price or strike skew: When options on the same underlying security have notably different IV across different strike prices.

Skew can sometimes be seen across different expiration months. If a biotechnology company has a blockbuster drug pending regulatory approval in a few days, for instance, it wouldn't be unusual, in anticipation of the event, to see IV in the short-term options rise above the IV of long-term options.

The options volatility skew can sometimes illustrate which direction the implied risk lies in an underlying security. There is, of course, a supply and demand variable that determines if there's a skew and how severe that skew (or IV differential) is. Without higher demand for some option strikes or expirations, skew would not exist because supply and demand for options is typically the main driver of IV.

And what about the options world beyond equities, such as options on futures? Some products can behave, and thus be priced, quite differently. Options on commodities, such as corn, cattle, and crude oil, for example, might have a natural upside skew, with OTM calls having a higher IV than OTM puts. For example, food and energy scarcity can sometimes lead to frenzied buying and heightened demand for call options with higher strike prices.

Other contracts, such as some foreign currencies, often have no "natural" options skew, and skew can vary depending on market conditions, expectations, and the supply and demand of upside versus downside options. 
 

General measurements of volatility like the Cboe VIX, rule of 16, and options skew don't necessarily tell the entire story as to whether an option might be overpriced or underpriced. Rather, they should be considered in the context of the bigger picture.

When looking at an individual equity, a variety of different events can affect skew. For example, is a company or one of its competitors about to report earnings, declare a dividend, or take other corporate action? Is there a merger or acquisition in the works? In the index market, global economic trends, market volatility, and changes in risk perceptions are often drivers of IV across expirations or strike prices, resulting in changes in skew.

And remember, a volatility reading only defines a statistical tendency. It is the investor's perception of the odds of a particular occurrence and not a sure thing. But understanding the VIX, rule of 16, and skew can at least offer some perspective to help make sense of the numbers.