What is the “VIX – CBOE Volatility Index”?
The Volatility Index (VIX) was created by the Chicago Board Options Exchange (CBOE) and measures the expected volatility of the US stock market. It generates a 30-day forward-looking estimate of volatility based on the prices of options on the S&P 500 index with short-term expiration dates. The more substantial the change in prices over the period, the higher the volatility. The VIX is also referred to as the “fear index” as it is perceived as an indicator of investor sentiment and a quantifiable estimate of market risk.
Key Learning Points
- The Volatility Index (VIX) measures the expected future volatility and is given as a percentage
- The VIX calculation method is based on the prices of options on the S&P 500 index with short-term expiration dates
- The VIX takes into account the premiums that investors are willing to pay for the right (option) to buy or sell a stock
- The VIX is forward-looking and often perceived as an indicator of market uncertainty, rather than a direct measure of volatility
How Does It Work?
It is important to highlight that VIX is a projection of future market movements rather than a direct indicator of current market volatility. It is designed to capture the average of how far the put and call options prices on the S&P 500 are distributed relative to the current prices of the index. The VIX is based on the premiums on options that investors are willing to pay as “insurance” against expected market volatility. Option premiums are considered to be a good indicator of the perceived level of market risk. Therefore the VIX will go up if premiums increase and will decline if premiums on options decline.
Typically, investors use options to hedge their positions when they foresee large market fluctuations. As a result, those who own call or put options will be willing to sell them only in exchange for a large premium. Therefore, an aggregate increase in option prices will drive the VIX up and signal greater expected market uncertainty. It is generally accepted that a reading above 30% is a sign of higher risk expectations, whereas values below 20% represent a moderate level of risk. When the VIX values are very low it could also imply that investors have a bearish outlook of the market.
The Use of VIX
The VIX is calculated by a rather complex method. Critics of the VIX argue that it represents a measure of the current price of index options and question its predictive powers of future short-term volatility being similar to that of simple calculations such as historical volatility.
Investors cannot directly trade the VIX, but gain exposure through exchange-traded products, options, or futures contracts. The main aim of this is portfolio diversification as historically VIX-linked instruments demonstrate a strong negative correlation to equity markets – if volatility goes up equity returns decline and vice versa. During times of market turbulence, VIX levels could be extremely high, but these are usually unsustainable for a long period as a result of investors reducing their risk exposure (which reduces the level of market uncertainty).
Below is a multiple-choice question to test your knowledge, download the accompanying Excel exercise sheet for a full explanation of the correct answer.