What the VIX measures DIRECTLY is the demand for options on the S&P 500 vs the supply of those options. In the most true sense, the VIX measures the "price" of those options.
If demand for stocks in the S&P 500 rises relative to the supply of those stocks, what happens? The price of those stocks goes up, and so does the index which measures them - the S&P 500.
Similarly, if the demand for options on the S&P 500 index rises relative to the supply of those options, what happens? The price of those options goes up, and so does the index which measures them - the VIX.
The next question is: What causes the demand for these options to rise relative to the supply?
The answer - as shown pretty convincingly by the charts I posted earlier - is "a drop in the S&P 500 causes the demand for those options to rise relative to their supply, and a rise in the S&P 500 causes the supply of those options to rise relative to their demand."
The next step is to determine why people want to buy options when the S&P 500 drops, and sell options when the S&P 500 rises.
I would argue that it's driven by emotion - fear and complacency. When stocks drop, people get nervous and are willing to spend a little more for insurance. When stocks rise, people breathe a sigh of relief.
Others here have argued that it's driven by people's estimate of future volatility. To accept that premise you would have to believe that people's estimate of future volatility goes up each time stocks drop, and goes down each time stocks rise - on a minute-by-minute, tick-by-tick basis. That makes less sense to me than the "fear/complacency" theory.
If demand for stocks in the S&P 500 rises relative to the supply of those stocks, what happens? The price of those stocks goes up, and so does the index which measures them - the S&P 500.
Similarly, if the demand for options on the S&P 500 index rises relative to the supply of those options, what happens? The price of those options goes up, and so does the index which measures them - the VIX.
The next question is: What causes the demand for these options to rise relative to the supply?
The answer - as shown pretty convincingly by the charts I posted earlier - is "a drop in the S&P 500 causes the demand for those options to rise relative to their supply, and a rise in the S&P 500 causes the supply of those options to rise relative to their demand."
The next step is to determine why people want to buy options when the S&P 500 drops, and sell options when the S&P 500 rises.
I would argue that it's driven by emotion - fear and complacency. When stocks drop, people get nervous and are willing to spend a little more for insurance. When stocks rise, people breathe a sigh of relief.
Others here have argued that it's driven by people's estimate of future volatility. To accept that premise you would have to believe that people's estimate of future volatility goes up each time stocks drop, and goes down each time stocks rise - on a minute-by-minute, tick-by-tick basis. That makes less sense to me than the "fear/complacency" theory.
