By Rachael Green, Benzinga
SPIKES Volatility Index is a measure of the 30-day expected volatility for the S&P500 ETF (SPY) and may be gaining in popularity as the new way to look at volatility, especially among traders.
Volatility trading has become a popular means of hedging portfolios or turning market assumptions into tradable opportunities, and subtle differences in the methodologies used to calculate SPIKES and VIX could make the former a more suitable index for those kinds of short-term trades. Here’s a quick look at how the two volatility measures differ and why that matters.
How VIX Methodology Works and Why Traders May Want an Alternative
VIX generates a quantified measure of future volatility by tracking options contracts, which grant the holder the right to buy or sell an underlying asset at a future date for a guaranteed price. An investor might buy a put option to sell a stock at $20 per share in 30 days if they believed the stock price might dip below $20 in that time period, for example. Alternatively, they might buy a call option to buy a stock at $20 per share in 30 days if they believed the stock’s price would rise above that price.
That function of either hedging losses or realizing gains the investor assumes will happen in the future is precisely why the options market is such a useful way to gauge near-term volatility and why VIX is sometimes called the “fear gauge.”
As useful as it is, VIX methodology for calculating its value comes with some limitations. Namely, it only tracks options traded on the CBOE Options Exchange and only the less liquid SPX options on that exchange. That limited dataset gives a peek into the S&P 500 options market but not the full picture.
SPX options are European-style options based on the S&P 500 index itself. That means the option contracts are larger (and more expensive), can’t be exercised before their expiration date, and trading stops the day before they expire. Those features make them less liquid and prone to wider spreads.
One drawback to that lack of liquidity and larger spread is that it can impact the midpoint formula the VIX uses to calculate options prices. The formula sets the price of options as the midpoint in their bid-ask spread. This more or less creates a theoretical “average” contract price rather than the actual price the contracts are trading at.
Finally, the VIX updates every 15 seconds, which isn’t a problem for long-term investors using it to check in on market sentiment and volatility. For short-term trading, however, those 15 seconds can be the crucial difference between a trade generating yield or losing money.
What the SPIKES Index Does Differently
The SPIKES Volatility Index (SPIKE) was designed specifically to address some of the limitations of VIX. While both are a measure of 30-day expected volatility of the S&P 500, one of the most notable differences is SPIKES use of SPY options rather than SPX options. SPY options are the most actively traded exchange-traded fund (ETF) in the world, with strong liquidity and potentially smaller spreads.
By tracking SPY options, the SPIKES Volatility Index seeks to minimize the impact of spread on price movements and provide a more precise measure of volatility. Another means of increasing that precision is the use of options data from all 16 U.S. options exchanges instead, whereas SPX options are only traded on one exchange.
Finally, SPIKES utilizes a proprietary price-dragging technique for capturing live options prices as an alternative to the midpoint pricing used for VIX. Rather than approximating an average price, SPIKES uses pricing data from actual trades. And instead of updating the index price every 15 seconds, it updates every 100 milliseconds for pinpoint accuracy, making it a viable tool for short-term traders.
Differences In Methodology Became Clear In The Aftermath Of Interest Rate Hikes
On Sept. 21, 2022, stock prices slumped after the Federal Reserve raised interest rates another 0.25% and provided a clear example of how SPIKES methodology results in a more stable index during moments of low liquidity or high volatility. While SPIKES and VIX move in tandem with each other most of the time, VIX diverged nearly 10% from SPIKES in the five-minute window following the Fed’s rate hike press release. During that window, SPIKES vacillated in the high 27s but VIX spiked above 30 and didn’t move until 2:06 p.m. when it tipped back down to realign with SPIKES. While you can’t trade the Index directly, there are options, futures, and ETFs available on SPIKES.
This article was originally published on Benzinga here.
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