The VIX Dog That Didn’t Bark

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In the story, “The Adventure of Silver Blaze”, Sherlock Holmes solves a mystery in part by when no one he’d spoken to during an investigation mentioned that they heard a dog bark the night a famous race horse was stolen and the horse trainer was killed in a stable. See the exchange below:

Scotland Yard Detective to Holmes: “Is there any other point to which you would wish to draw my attention?”

Sherlock Holmes: To the curious incident of the dog in the night-time.”

Scotland Yard Detective: “The dog did nothing in the night-time.”

Sherlock Holmes: “That was the curious incident!”

The fact the dog didn’t bark led Holmes to the conclusion that the evildoer was not a stranger to the dog. Otherwise, the dog would have barked. Holmes deduced that because the dog didn’t bark (a negative fact), it had to be someone who was familiar to the dog and horse stable.

Option prices, including the VIX index, have failed to provide advance warning of market crashes from Black Monday to last year’s coronavirus crash. It is a dog that doesn’t bark.

I will review the data supporting that observation and the implications for investors. First, however, let’s review how the VIX works.

In January 1983, the Commodity Futures Trading Commission (CFTC) approved the first options based on stock index futures contracts, including an option on the Standard & Poor's 500 Index (SPX) futures contract on the Chicago Mercantile Exchange. In March 1983, options contracts based on the S&P 100 index began trading on the Chicago Board Options Exchange (now known as Cboe®). Four months later, options contracts started trading on the S&P 500 Index®.1 {An option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a strike price on or before the option's expiration date. These options work similarly to individual stock or index options but differ because the underlying security is a futures contract regulated by the CFTC.}