Nature of Option Trading and the VIX Index

Nature of Option Trading and the VIX® Index

A frequently-asked question is, "Why do SPX and the VIX index move in opposite directions?"

The answer to this question is rooted in the nature of option trading that occurs on days when the market is down versus days when the market is higher. It seems that the "order flow" - the pace and types of orders that come into the marketplace - in SPX options is different on bullish days compared to bearish days.

Consider a day when SPX is declining. On such a day, market participants may be looking for ways to protect their portfolios against further market declines. Since purchasing SPX put options is an easy and effective hedging mechanism, the increased demand for SPX put options causes the relative price and, therefore, the implied volatility of these options in increase. Since the VIX index is a measure of SPX implied volatility, the VIX index moves higher because of this increase in demand for SPX put options.

Now consider the behavior of option market participants when the SPX is rising. SPX options traders do not seem to rush into buying SPX call options when the market is rising in the same way that they seem to plunge into buying puts when the market is falling. As a result, the order flow in SPX options on rising days seems to be more balanced between buyers and sellers. The result is steady or falling implied volatility of SPX contracts. And, again, since the VIX index measures this implied volatility, the VIX index tends to stay steady or decline on days when SPX rises.

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