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What Is the CBOE Volatility Index (VIX)?

The $Cboe Volatility Index(VIX)$ is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the $S&P 500(.SPX)$ index. Because it is derived from the prices of SPX index options with near-term expiration dates, it generates a 30-day forward projection of volatility. Volatility, or how fast prices change, is often seen as a way to gauge market sentiment, and in particular the degree of fear among market participants.

The index is more commonly known by its ticker symbol and is often referred to simply as “the VIX.” It was created by theChicago Board Options Exchange (CBOE) and is maintained by CBOE Global Markets. It is an important index in the world of trading and investment because it provides a quantifiable measure of market risk and investors’ sentiments.

KEY TAKEAWAYS

• The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days.
• Investors use the VIX to measure the level of risk, fear, or stress in the market when making investment decisions.
• Traders can also trade the VIX using a variety of options and exchange-traded products, or use VIX values to price derivatives.

How Does the VIX Work?

The VIX attempts to measure the magnitude of price movements of the S&P 500 (i.e., its volatility). The more dramatic the price swings are in the index, the higher the level of volatility, and vice versa. In addition to being an index to measure volatility, traders can also trade VIX futures, options, and ETFs to hedge or speculate on volatility changes in the index.

In general, volatility can be measured using two different methods. The first method is based on historical volatility, using statistical calculations on previous prices over a specific time period. This process involves computing various statistical numbers, likemean(average),variance, and finally, thestandard deviationon the historical price data sets.

The second method, which the VIX uses, involves inferring its value as implied byoptionsprices. Options arederivativeinstruments whose price depends upon the probability of a particular stock’s current price moving enough to reach a particular level (called thestrike priceorexercise price).

Since the possibility of such price moves happening within the given time frame is represented by the volatility factor, various option pricing methods (like theBlack-Scholes model) include volatility as an integral input parameter. Since option prices are available in the open market, they can be used to derive the volatility of the underlying security. Such volatility, as implied by or inferred from market prices, is called forward-lookingimplied volatility (IV).

Extending Volatility to Market Level

The VIX was the first benchmark index introduced by CBOE to measure the market’s expectation of future volatility. Being a forward-looking index, it is constructed using the implied volatilities on S&P 500 index optionsand represents the market’s expectation of 30-day future volatility of the S&P 500 index, which is considered the leading indicator of the broad U.S. stock market.

Introduced in 1993, the VIX is now an established and globally recognized gauge of U.S. equity market volatility. It is calculated in real time based on the live prices of the S&P 500 index. Calculations are performed and values are relayed from 3 a.m. to 9:15 a.m., and from 9:30 a.m. to 4:15 p.m. EST. CBOE began the dissemination of the VIX outside of U.S. trading hours in April 2016.1

Calculation of VIX Values

VIX values are calculated using the Cboe-traded standard SPX options, which expire on the third Friday of each month, and the weekly SPX options, which expire on all other Fridays. Only SPX options are considered whose expiry period lies within more than 23 days and less than 37 days.

While the formula is mathematically complex, it theoretically works as follows: It estimates the expected volatility of the S&P 500 index by aggregating the weighted prices of multiple SPX puts and calls over a wide range of strike prices. All such qualifying options should have valid nonzero bid and ask prices that represent the market perception of which options’ strike prices will be hit by the underlying stocks during the remaining time to expiry.

For detailed calculations with an example, one can refer to the section “The VIX Index Calculation: Step-by-Step” of the VIXwhite paper.

Evolution of VIX

During its origin in 1993, VIX was calculated as a weighted measure of the implied volatility of eight S&P 100at-the-money put and call options, when the derivatives market had limited activity and was in its growing stages. As the derivatives markets matured, 10 years later, in 2003, the CBOE teamed up with Goldman Sachs and updated the methodology to calculate VIX differently. It then started using a wider set of options based on the broader S&P 500 index, an expansion that allows for a more accurate view of investors’ expectations on future market volatility. A methodology was adopted that remains in effect and is also used for calculating various other variants of the volatility index.

VIX vs. S&P 500 Price

Volatility value, investors’ fear, and VIX values all move up when the market is falling. The reverse is true when the market advances—the index values, fear, and volatility decline.

The price action of the S&P 500 and the VIX often shows inverse price action: when the S&P falls sharply, the VIX rises—and vice-versa.

As a rule of thumb, VIX values greater than 30 are generally linked to large volatility resulting from increased uncertainty, risk, and investors’ fear. VIX values below 20 generally correspond to stable, stress-free periods in the markets.

How to Trade the VIX

The VIX has paved the way for using volatility as a tradable asset, albeit through derivative products. Cboe launched the first VIX-based exchange-tradedfutures contract in March 2004, followed by the launch of VIX options in February 2006.

Such VIX-linked instruments allow pure volatility exposure and have created a new asset class. Active traders, large institutional investors, and hedge fund managers use the VIX-linked securities forportfoliodiversification, as historical data demonstrates a strong negativecorrelationof volatility to the stock market returns—that is, when stock returns go down, volatility rises, and vice versa.

Like all indexes, one cannot buy the VIX directly. Instead, investors can take a position in VIX through futures or options contracts, or through VIX-basedexchange-traded products (ETPs). For example, the ProShares VIX Short-Term Futures ETF (VIXY), the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB), and the VelocityShares Daily Long VIX Short-Term ETN (VIIX) are many such offerings that track a certain VIX-variant index and take positions in linked futures contracts.

Active traders who employ their owntrading strategiesand advanced algorithms use VIX values to price the derivatives, which are based on high beta stocks.Beta represents how much a particular stock price can move with respect to the move in a broader market index. For instance, a stock having a beta of +1.5 indicates that it is theoretically 50% more volatile than the market. Traders making bets through options of such high beta stocks utilize the VIX volatility values in appropriate proportion to correctly price their options trades.

Following the popularity of the VIX, the CBOE now offers several other variants for measuring broad market volatility. Examples include the CBOE Short-Term Volatility Index (VXSTSM), which reflects the nine-day expected volatility of the S&P 500 index; the CBOE S&P 500 3-Month Volatility Index (VXVSM); and the CBOE S&P 500 6-Month Volatility Index (VXMTSM). Products based on other market indexes include the Nasdaq-100 Volatility Index (VXNSM); the CBOE DJIA Volatility Index (VXDSM); and the CBOE Russell 2000 Volatility Index (RVXSM).1Options and futures based on RVXSM are available for trading on CBOE and CFE platforms, respectively.

What Does the Cboe Volatility Index (VIX) Signal?

The Cboe Volatility Index (VIX) signals the level of fear or stress in the stock market—using the S&P 500 index as a proxy for the broad market—and hence is widely known as the “Fear Index.” The higher the VIX, the greater the level of fear and uncertainty in the market, with levels above 30 indicating tremendous uncertainty.

How Can an Investor Trade the VIX?

Like all indices, the VIX cannot be bought directly. However, the VIX can be traded through futures contracts andexchange traded funds (ETFs)andexchange traded notes (ETNs)that own these futures contracts.

Does the level of the VIX affect option premiums and prices?

Yes, it does. Volatility is one of the primary factors that affect stock and index options’ prices and premiums. As the VIX is the most widely watched measure of broad market volatility, it has a substantial impact on option prices or premiums. A higher VIX means higher prices for options (i.e., more expensive option premiums) while a lower VIX means lower option prices or cheaper premiums.

How can I use the VIX level to hedge downside risk?

Downside riskcan be adequately hedged by buying put options, the price of which depend on market volatility. Astute investors tend to buy options when the VIX is relatively low and put premiums are cheap. Such protective puts will generally get expensive when the market is sliding; therefore, like insurance, it’s best to buy them when the need for such protection is not obvious (i.e., when investors perceive the risk of market downside to be low).

source: investopedia