What is VIX Volatility Index?
The VIX Volatility Index is a real-time measure of the stock market’s expectation of volatility implied by the S&P 500 index options. In other words, it reflects the market’s consensus on how much the S&P 500 index will fluctuate in the future. The VIX is sometimes referred to as the “fear index” because it tends to rise during times of market uncertainty and decline during periods of relative stability. It is calculated and published by the Chicago Board Options Exchange (CBOE). Traders and investors use the VIX as a gauge of market sentiment and risk, and it is widely considered to be one of the most important barometers of stock market volatility.
How is the VIX Calculated?
The VIX is calculated using the prices of options on the S&P 500 index. More specifically, it uses the prices of both put and call options with a range of expiration dates. The options used in the calculation are specifically chosen to be near the at-the-money strike price, meaning that the strike price is close to the current market price of the S&P 500 index.
The VIX calculation uses a formula that takes into account the prices of these options to estimate the market’s expectation of volatility over the next 30 days. The formula is based on the Black-Scholes model, which is a widely used model for valuing options. However, because the VIX uses options with a range of expiration dates, the calculation is more complex than the basic Black-Scholes model.
The VIX calculation involves several steps, below is a list of those steps.
- Selecting the set of options to use in the calculation. The options are typically chosen to be those with expiration dates that are closest to 30 days in the future, but that still have a significant amount of time until expiration.
- Calculating the implied volatility for each option. Implied volatility is the level of volatility that is implied by the current market price of an option. The implied volatility for each option is calculated using the Black-Scholes model.
- Weighting the implied volatility for each option based on its contribution to the overall volatility of the S&P 500 index. This is done using a specific weighting scheme that takes into account the strike price of each option and its time until expiration.
- Combining the weighted implied volatility for all the options to arrive at the VIX value. The VIX is expressed as a percentage, representing the expected annualized volatility of the S&P 500 index over the next 30 days.
History of the Volatility Index
The history of the VIX dates back to 1993 when the Chicago Board Options Exchange (CBOE) introduced it as a measure of expected volatility in the stock market. Initially, the VIX was based on the implied volatility of eight S&P 100 index options, but it was later revised to use options on the broader S&P 500 index.
The VIX gained widespread attention in the early 2000s during the dot-com bubble and subsequent market downturn. During this time, the VIX reached record highs as investors became increasingly concerned about the state of the economy and the stock market.
The VIX reached its all-time high of 80.86 in November 2008 during the global financial crisis. During this period, the VIX remained elevated for several months, indicating high levels of market uncertainty and volatility.
Since then, the VIX has continued to be closely watched by traders, investors, and analysts as a measure of market volatility and risk. In recent years, the VIX has been used to track market sentiment during major events such as the Brexit vote, the U.S. presidential election, and the COVID-19 pandemic.
Pros and Cons
Pros of using the VIX
Measure of Market Volatility: The VIX is a real-time measure of the stock market’s expectation of volatility. It provides traders, investors, and analysts with valuable insights into the level of uncertainty in the market and the potential risk of holding a portfolio of stocks.
Indicator of Market Sentiment: The VIX is often referred to as the “fear index” because it tends to rise during times of market uncertainty and decline during periods of relative stability. As such, it can be used as an indicator of market sentiment and investor confidence.
Risk Management Tool: The VIX can help investors manage risk in their portfolios. By monitoring the VIX, investors can make informed decisions about when to reduce their exposure to stocks or increase their holdings of defensive assets like bonds.
Hedging Tool: The VIX can be used as a hedging tool to protect against market downturns. For example, investors may buy put options on the S&P 500 index when the VIX is high to protect their portfolios from potential losses.
Trading Opportunities: Traders can use the VIX to identify opportunities to buy or sell volatility. For example, traders may buy VIX futures or options if they believe that volatility will increase in the future.
The VIX is an important tool for understanding market sentiment, managing risk, and identifying trading opportunities. It provides valuable insights into the level of uncertainty in the market and helps investors and traders make informed decisions about their portfolios.
Cons of using the VIX
Complex calculation: The VIX is calculated using a complex formula that takes into account the prices of a variety of call and put options on the S&P 500 index. This can make it difficult for some investors and traders to understand.
Limited historical data: The VIX has only been in use since 1993, which means that there is a relatively limited amount of historical data available for analysis.
Can be volatile: The VIX itself can be volatile, with sudden spikes in the index often occurring during times of market stress. This can make it difficult to predict market movements and can lead to sudden losses for investors and traders.
The VIX is a real-time measure of the stock market’s expectation of volatility, based on the implied volatility of S&P 500 index options. It is an important tool for understanding market sentiment, managing risk, and identifying trading opportunities. The VIX provides valuable insights into the level of uncertainty in the market and helps investors and traders make informed decisions about their portfolios.
However, the VIX can also be complex to calculate and volatile in its movements, which can make it challenging to use effectively. Nonetheless, the VIX remains a widely used and respected tool for traders and investors around the world.