The Volatility Index, formerly known as the Chicago Board Options Exchange (CBOE), is a representation of what the market is expected to do in terms of 30-day volatility. The VIX is made up of multiple S&P 500 index options and the implied volatilities that comprise them. Take note that volatility is geared towards the future and it is calculated by means of put options and call options. When the VIX is discussed, it is essentially known as an investor fear gauge – a way of assessing overall market risk. The VIX is not the only investor fear gauge in the markets – there are others as well, including the VXD which tracks the DJIA (Dow Jones Industrial Average) and the VXN which tracks the NASDAQ 100.
Understanding the VIX – Volatility Index
Back in 1993, the Chicago Board Options Exchange (CBOE) introduced the very first VIX. At the time, it was a weighted measure comprising 8 x S&P 100 stocks. By 2003, the VIX was expanded to a broader index known as the S&P 500. The S&P 500 is all encompassing and allows for a much more accurate gauge of market volatility and the overall expectations of investors. When measuring the volatility index (the VIX), any number lower than 20 is considered to be a complacent and stress-free economic situation. A VIX figure bigger than 30 is associated with high volatility. What this means is that investors have a large degree of uncertainty or fear in the way the market is behaving.
Which way is the Market Moving with VIX?
First off, it should be understood that the VIX is useful for market-timing purposes. Since it is used to measure implied volatility, it has no bearing on statistical volatility or historical volatility at all. It is based across a wide range of options on the S&P 500 index. The VIX is a fear index, and it is geared towards short-term volatility, which is the equivalent of short-term risk. The VIX typically rises during stressful financial times and falls when economic stress factors diminish or dissipate. The higher the VIX figure the greater the short-term volatility in the financial markets. When we speak of implied volatility, we are making reference to the underlying volatility in the market. Since the S&P 500 index is a broad index, it is simply the price volatility that we are focusing on. If it is ascertained that the implied volatility is high then so too will the premium on options be high. As option premiums increase – on average – there is an expectation that the future volatility will be higher vis-a-vis the VIX.
The VIX naturally impacts on the behaviour of stock markets. As we have already established, a high VIX number is representative of a higher degree of investor fear and uncertainty. The converse also holds true. Not surprisingly, the pattern between stock market behaviour and implied volatility has proven itself time and again, in both bull markets in bear markets. It makes perfect sense that a market characterised by high volatility will show a high VIX figure. This is a result of the panic selling/emotional selling that takes place in financial markets. When a market is enjoying a bull run, the amount of fear in the markets is greatly diminished. Therefore, the need to hedge against strong growth decreases and less put options are placed.
There is tremendous value to using the VIX gauge to analyse the markets. Since the VIX measures market sentiment during the day, and from day-to-day, it is a useful economic tool to focus on troughs and peaks over the medium-term. The manner in which the VIX is used can become quite complicated, since there is significant statistical and mathematical modelling worked into the index. Suffice it to say, it is possible to simply look at the actual level of the VIX or to compare it by using ratios. This is known as de-trending. There are some interesting patterns that have been deciphered by using the VIX, S&P 500 and oscillator. For example once the volatility index moves below 20, widespread sell-offs have taken place shortly after that.
How do You Calculate the Value of the VIX?
The VIX is no longer known as the CBOE Volatility Index; it now goes by the name VIX and it is specifically used for tracking the volatility of the S&P 500. The mathematical equations used to calculate the VIX are complex.
In short, the VIX is calculated as follows: VIX = 100 x σ.
Investors are particularly interested in implied volatility since this is the perfect tool to evaluate market sentiment. And in so doing, volatility measures such as VIX allow for lucrative investment options. This is particularly useful when it comes to hedge risk. It should be borne in mind that volatility is not only used to measure bearish trends; it can also be used for bullish trends. Whether the movement is upwards/downwards, VIX measures allow for speculation in the financial markets. Among others the following trades can be made: Exchange Traded Funds (ETFs), and Exchange Traded Notes (ETNs). Each of these options has pros and cons, and careful scrutiny is required before investment decisions are made.
The VIX Option
The VIX has become so popular, that it now stands as its own non-equity option. In other words it can be traded. In much the same way as the S&P 500 index is an overall index of the top 500 companies and it has a value, the Volatility Index (VIX) can likewise be traded based on the sentiment that traders and investors have to current market conditions. It is a speculative index and it is a great way to hedge against market declines. The VIX option is essentially a foolproof way to bet against the market in the event that you lose. This is why it is considered an effective hedging strategy as the volatility increases as market performance decreases.