What Does the CBOE Volatility Index (VIX) Measure for Investing Purposes?

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The Cboe Volatility Index (VIX): What Is It?

The market’s expectations for the relative strength of impending price swings of the S&P 500 Index are within the Cboe Volatility Index (VIX), a live index (SPX). It produces a 30-day forecast of volatility since it is drawn from the pricing of SPX index options with close-in expiry dates. Volatility, or how quickly prices fluctuate, is frequently used to assess market emotion, particularly the level of anxiety among traders.

The index is frequently referred to as “the VIX” despite being more well-recognized by its ticker symbol. It is managed by Cboe Global Markets and was developed by the Cboe Options Exchange (Cboe). Because it offers a measurable gauge of market risk and investor emotion, it is a crucial index in trading and investing.

KEY TAKEAWAYS

  • The Cboe Volatility Index, sometimes known as VIX, is a real-time market index that gauges how much volatility the market anticipates over the next 30 days.
  • When making investing decisions, investors use the VIX to gauge the amount of risk, anxiety, or tension in the market.
  • Traders can price derivatives using VIX values or trade the VIX using various options and exchange-traded products.
  • The VIX often goes up when equities are down and down when they are up.

What Is the Function of the Cboe Volatility Index (VIX)?

The S&P 500’s price swings are gauged using the VIX (i.e., its volatility). The number of volatility rises directly to how dramatically the index’s price swings change and vice versa. In addition to using VIX as a volatility index, traders may also use it to bet on changes in volatility by trading VIX futures, options, and ETFs.

Generally speaking, there are two ways to calculate volatility. The first approach uses statistical calculations on prior prices over a given period and is based on historical volatility. Numerous statistical quantities such as mean (average), variance, and standard deviation are calculated on the historical pricing data sets.

The VIX employs the second technique, which entails estimating its value based on implied option prices.

Options are derivative financial products, and the price of an option depends on the likelihood that the price of a particular stock will increase by a specific amount (called the strike price or exercise price).

The volatility factor, an important input parameter for many option pricing models (including the Black-Scholes model), represents the likelihood that such price changes will occur within the specified period. Since market participants may find option prices on the open market, traders can use them to calculate the underlying security’s volatility. This volatility is referred to as forward-looking implied volatility when it is suggested by or inferred from market prices (IV).

Volatility Extending to Market Level

The VIX was the first benchmark index created by Cboe to gauge market expectations for future volatility. It is a forward-looking index that captures the market’s anticipation of the 30-day future volatility of the S&P 500 Index, which is regarded as the leading indicator of the whole U.S. stock market. The implied volatilities on S&P 500 index options form the index. 

The VIX, first released in 1993, is now a well-established and well-known indicator of volatility in the U.S. equities market. It is determined in real-time using current S&P 500 Index values. From 3 a.m. to 9:15 a.m. and from 9:30 a.m. to 4:15 p.m. EST, calculations are carried out, and values are transmitted. In April 2016, Cboe started distributing the VIX outside U.S. trading hours. 

Values of VIX are calculated.

The Cboe-traded standard SPX options, which expire on the third Friday of the month, and the weekly SPX options, which expire on the other Fridays, are used to determine VIX values. Only SPX options with expiration dates that are between 23 and 37 days are taken into account.

Though analytically challenging, the formula theoretically operates as follows: By combining the weighted values of several SPX puts and calls over a wide range of strike prices, it calculates the anticipated volatility of the S&P 500 Index. The market impression of which the underlying equities will reach options’ strike prices during the period left before expiration should be reflected in all such qualifying options’ legitimate nonzero bids and ask prices.

The portion of the VIX white paper titled “The VIX Index Calculation: Step-by-Step” contains extensive calculations and an example.

Changes in the VIX

When the derivatives market had little activity and was still developing in 1993, the VIX was computed as a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options.

Ten years later, in 2003, The CBOE collaborated with Goldman Sachs to revise the algorithm to compute VIX in a new way as the derivatives markets evolved. A broader range of options based on the S&P 500 Index was subsequently used, providing a more realistic picture of investors’ expectations for future market volatility. A technique was chosen which is still used today to compute several more volatility index versions. 

S&P 500 Price vs. VIX

When the market declines, the volatility value, investors’ worry, and VIX values all increase. Index values, anxiety, and volatility decrease when the market moves in the other direction.

The price movement of the S&P 500 and the VIX frequently exhibits inverse price action, with the VIX rising when the S&P falls dramatically and vice versa.

As a general rule, VIX levels of more than 30 are typically associated with high volatility brought on by elevated risk, uncertainty, and investor anxiety. Markets are typically steady and stress-free when the VIX is below 20.

The VIX Trading Process

The VIX opened the door for trading volatility as an asset, albeit through derivatives. In March 2004, Cboe introduced the first exchange-traded futures product based on the VIX index. In February 2006, VIX options were introduced. 

These VIX-linked products provide only exposure to volatility and have given rise to a new asset class. Active traders, significant institutional investors, and hedge fund managers use VIX-linked securities to diversify their portfolios because historical data shows that volatility and stock market returns have a strong inverse relationship. In other words, when stock returns decline, volatility increases, and vice versa.

Like other indices, the VIX cannot be purchased directly. Instead, investors can purchase VIX through futures, options, or exchange-traded instruments based on the VIX (ETPs). For instance, two products that track a specific VIX-variant index and take positions in associated futures contracts are the ProShares VIX Short-Term Futures ETF (VIXY) and the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB).

Based on high beta equities, the derivatives are priced using VIX values by active traders who utilize their trading tactics and sophisticated algorithms. A stock’s beta value indicates how much it can fluctuate with the movement of a larger market index. For instance, a stock with a beta of +1.5 would be 50% more volatile than the market in theory. The VIX volatility levels are used by traders who bet on options of such high beta equities in the proper proportion to price their option transactions.

Following the VIX’s success, the Cboe now provides several additional options for gauging overall market volatility. Examples include the Cboe S&P 500 3-Month Volatility Index (VIX3M), the Cboe S&P 500 6-Month Volatility Index, and the Cboe Short-Term Volatility Index (VIX9D), which represents the nine-day projected volatility of the S&P 500 Index (VIX6M). The Nasdaq-100 Volatility Index (VXN), Cboe DJIA Volatility Index (VXD), and Cboe Russell 2000 Volatility Index are among the products based on other market indices (RVX). 6 Trading is permitted on the Cboe and CFE platforms for options and futures based on VIX products.

What Can We Learn from the VIX?

The Cboe Volatility Index (VIX), sometimes referred to as the “Fear Index,” measures the amount of anxiety or stress in the stock market using the S&P 500 index as a proxy for the entire market. The VIX index measures market fear and uncertainty, and a reading above 30 indicate extremely high uncertainty levels.

How Does a Trader Trade the VIX?

The VIX cannot be bought directly, like other indexes. However, futures contracts, exchange-traded funds (ETFs), and exchange-traded notes (ETNs) that hold these futures contracts can be used to trade the VIX.

Does the VIX Index Level Affect Option Prices and Premiums?

It does. Volatility is one of the key elements influencing the values and premiums of stock and index options. Given that the VIX is the most frequently followed indicator of overall market volatility, it significantly affects option premiums or prices. A higher VIX indicates higher option prices (and hence, larger option premiums), whereas a lower VIX indicates lower option prices or premiums.

How Can I Hedge Downside Risk Using the VIX Level?

Purchasing put options, the price of which depends on market volatility can effectively hedge downside risk. Intelligent investors are more likely to buy options when the VIX is relatively low and put premiums are affordable. Similar to insurance, it is advisable to purchase such protective puts when the need for such protection is not immediately apparent because they will typically become expensive when the market is declining (i.e., when investors perceive the risk of market downside to below).

What Is the VIX’s Typical Value?

The VIX has a long-term average of roughly 21.4. The VIX can indicate higher volatility and panic in the market at high levels (often when it is above 30), which are frequently linked to bear markets.

https://www.investopedia.com/terms/v/vix.asp

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