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Understanding the Rule of 16, Options Volatility Skew, and VIX

June 7, 2016
Frown upside down: learning more about the market's

Modern investors get frequent updates on where the CBOE Market Volatility Index (VIX) is trading. 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 volatility, what it means, how to measure it, and finally, how to determine its most accurate value.

What’s the Rule of 16?

The VIX was introduced by the CBOE in 1993 as a weighted measure of the implied volatility (IV) of the S&P 100 Index. In 2003, the VIX expanded to measure the S&P 500 index (SPX). The VIX quickly 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 the SPX. Without getting into a long math discussion involving square roots, let me simplify an interesting aspect of the VIX: the number 16 (or more precisely, 15.87) is approximately the square root of 252 (the number of trading days in a year). This is where the Rule of 16 comes from.

While you let that sink in, let’s walk through some hypotheticals. If the VIX is trading at 16, then 68.2% (or two-thirds) of the time, it might trade up or down by less than 1%. The other 31.8% (or one-third) of the time, the SPX might trade up or down by more than 1%.

Now let’s go further. The VIX at 24 might equate to a 1.5% move in the SPX 31.8% (one-third) of the time. Finally, a VIX at 32 might equate to a 2% move in the SPX 31.8% (one-third) of the time.

These VIX levels and understanding the probability of movement in the SPX can give investors a measuring stick to test if the market movement and measured volatility are in line.

Volatility Skew: Just the Facts

Now that we’ve discussed the Rule of 16, let’s tackle skew.

Skew shows up when out-of-the-money (OTM) put IV is at a higher level than OTM call volatility, causing higher premiums on the put side. This comes from the perception that stocks fall faster than they rise.

The option volatility skew illustrates which direction the implied risk lies in an underlying. 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 this demand, skew would not exist, because supply and demand for options is the clearest driver of IV.

Recognizing the existence of skew is the first step to considering it in your trading. With extra premium in OTM puts and conversely lower premiums in OTM calls, strikes can be chosen to potentially enhance trades using the divergence that skew imposes on option markets. Skew allows investors to push the put strike further out than a corresponding call side, providing less downside exposure.

In rare cases (stock splits or potentially positive news events), skew can flatten or even slightly shift positive to the call side (OTM calls with higher IV than OTM puts). This is a rare but very informative set of circumstances in equity options.

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