What is the CBOE Volatility Index (VIX)?
The CBOE Volatility Index (VIX) is a real-time index representing the market’s expectations for the relative strength of near-term price changes in the S&P 500 Index (SPX). Derived from the prices of SPX index options with near-term expiration dates, it provides a 30-day forward projection of volatility. Often referred to simply as the VIX, it is crucial for traders and investors as it offers a measure of market risk and sentiment.
Key Takeaways
- The VIX symbolizes the market’s expectations for volatility over the next 30 days.
- Investors use the VIX to gauge market risk, fear, or stress when making investment decisions.
- The VIX increases when stocks drop and decreases when stocks rise, creating an inverse relationship.
- Traders can engage with the VIX via various options and exchange-traded products or use its values to price derivatives.
Decoding the Mechanism of the VIX
The VIX measures the magnitude of price movements of the S&P 500, aka, its volatility. Larger price swings indicate higher volatility. Apart from just measuring, traders can also engage in VIX futures, options, and ETFs to hedge or speculate on volatility changes.
Measuring Volatility
Volatility can be measured using two methods:
- Historical Volatility: Statistical calculations on previous prices over a defined period, computing metrics like mean, variance, and standard deviation.
- Implied Volatility: The VIX uses this method, inferring volatility from option prices. These prices depend on the stock’s probability of hitting certain price levels (strike prices or exercise prices). Forward-looking implied volatility (IV) is derived from market prices, indicating market nervousness or risk.
Extending Volatility to Market Level
The VIX, introduced in 1993 by the CBOE, was the first benchmark index to gauge market expectations of future volatility. Real-time calculations are based on live prices of S&P 500 options from 3 a.m. to 4:15 p.m. EST, available even outside U.S. trading hours since April 2016.
Calculating VIX Values
VIX values are computed using standard SPX options that expire every Friday. These sole SPX options should lie within a period of more than 23 but less than 37 days. The value is determined by aggregating the weighted prices of numerous SPX puts and calls over varied strike prices.
Evolution of the VIX
Spearheaded in 1993, the VIX originated by measuring implied volatility through a weightage of eight S&P 100 options. As the derivatives market matured, by 2003, its methodology was updated to leverage a broad set of S&P 500 options, providing a more comprehensive view of market volatility.
VIX vs. S&P 500 Price Movements
Volatility and investor dread heighten when the market dips. Conversely, market growth diminishes the VIX. Values over 30 signify substantial uncertainty and risk, while under 20 signals a stable market period.
Mastering the Art of Trading VIX
VIX turned volatility into a tradable asset via derivative products. Starting with the first VIX-based futures contract in 2004 and options in 2006, it became instrumental for portfolio diversification. Traders majorly employ VIX-linked securities like ETFs or ETNs to engage in VIX trading.
Common products include:
- ProShares VIX Short-Term Futures ETF (VIXY)
- iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB)
What Does the VIX Tell Us?
The VIX signals overall market angst as it uses S&P 500 index volatility as a proxy. A higher VIX denotes greater fear and uncertainty.
Investing in the VIX
Although direct purchase of the VIX is impossible, it can be traded through futures contracts, ETFs, and ETNs holding those futures.
VIX Influence on Option Premiums and Prices
Volatility heavily influences option premiums, with high VIX leading to pricier options, indicating heightened market risk.
Utilizing the VIX to Hedge Downside Risk
By deploying strategies like buying put options when the VIX is low, investors can hedge downside risk. Pricing these protective puts predominantly relies on market volatility.
What Constitutes a Normal VIX Value?
Typically, the VIX hovers around an average value of 21. Values above 30 often herald increased volatility and a bearish market outlook.
Related Terms: implied volatility, options trading, market sentiment, S&P 500 Index, futures contracts.
References
- Cboe. “VIX Volatility Suite”.
- Cboe. “Cboe VIX White Paper: Cboe Volatility Index”, Pages 3–4.
- Cboe. “Cboe VIX White Paper: Cboe Volatility Index”, Page 5.
- Cboe. “VIX Index Historical Data”.
- Robert E. Whaley. “Understanding VIX”, Click Download PDF, Page 2.
- Cboe. “Cboe VIX White Paper: Cboe Volatility Index”, Page 4.
