What is the Volatility Index (VIX)?
Investors are often wary of market volatility, especially the wild swings experienced during the 2008 financial crisis and during the COVID-19 pandemic. It’s natural for investors to monitor how the stock market moves and how they can profit from forecasting future changes. Some investors turn to the Volatility Index, also known as the “fear index” or “stock market barometer” to gauge the sentiment of fellow stock market investors, to capitalize on anticipated market movements.
Learn more about the Volatility Index, what it means, and how it is calculated.
What Is the Volatility Index?
The Volatility Index (VIX) is a benchmark or real-time market index used to measure the expected volatility in the U.S. stock market. It is a product of the Chicago Board Options Exchange (CBOE), introduced in 1993 and is usually maintained by CBOE Global Markets. The VIX is based on the option prices of the S&P 500 and combines the weighted prices of the S&P 500’s call and put options for the next 30 days.
For investors, the VIX provides an efficient method to assess market uncertainty and risk before making trading decisions.
How Does the Volatility Index Work?
As mentioned earlier, the Volatility Index tracks the expected volatility of the stock market depending on how the prices of S&P 500 options change. Using a complicated formula, the VIX is calculated and expressed as a percentage.
In the stock market, the VIX measures the general market sentiment and bears a negative correlation with the stock market returns. When the VIX moves up, it means there’s heightened fear among investors. In this case, the S&P 500 may start witnessing a fall in prices as investors rush to sell securities to hedge against the expected volatility.
Similarly, when the VIX falls, it signals a decline in fear among investors. In this case, the general market could be experiencing lower volatility levels and higher security prices as investors trade with more confidence. However, this isn’t a guarantee that prices will remain high since volatility can decrease or increase rapidly in a changing market environment.
Although the VIX largely measures volatility in the S&P 500, it’s often used as a benchmark for the broader U.S. stock market. It’s difficult to predict current volatility, so investors often use the VIX together with a historical analysis of support and resistance levels.
Investors cannot directly trade the VIX, but often use exchange-traded funds (ETFs) or ETNs tied to the index to gain exposure.
How Is the VIX Calculated?
Calculating the VIX involves complex mathematics, but you don’t necessarily need to understand the intricacies in order to trade it. For starters, the Volatility Index is calculated on a real-time basis using live prices of the S&P 500 options. This includes CBOE SPX options that expire on the third Friday of each month as well as weekly on Friday. An option must carry an expiry date in the range of 23 to 37 days to be considered. The formula to calculate the VIX is shown below.
From a technical perspective, the formula looks at the variation in option prices with the same expiration date. However, the simple theory behind it is that, after combining weighted prices of a series of S&P 500 call and put options with multiple strike prices, we estimate the prices at which investors are willing to buy or sell the S&P 500. The final percentage value helps us estimate the future volatility of the market.
You can read the VIX as a chart that plots each day’s reading. A reading within the 0 to 12 range signals low market volatility, while anything between 13 and 20 represents normal volatility. Once the VIX reading exceeds 30, you expect that volatility will be higher in the coming 30 days.
How to Trade the VIX
When you trade the VIX, you’re not trading any asset directly since there’s no asset to purchase or sell. However, you can trade this index through derivative products that track its price. First, you can trade the VIX through futures contracts. VIX futures face the risk of contango, future VIX contracts are priced higher than current or shorter-term contracts.
To avoid the risks and complexity of trading VIX options and derivatives, traders can also buy VIX exchange-traded products, including exchange-traded notes (ETNs) and exchange-traded funds (ETFs).
Why Do You Need the Volatility Index?
The CBOE Volatility Index is important for traders and investors alike. A higher VIX value means there’s an expectation that stocks will have erratic price movements. For a trader, a high VIX could imply higher option prices. Traders may also short-sell stocks when the Volatility Index is rising. For the normal investor, the VIX can help in predicting market movements. Value investors may use a higher VIX to identify quality companies whose share price may have dropped. The VIX can also provide bearish signals for other investors. Both traders and investors can use the VIX to gauge the sentiment or mood in the market.
What Is a Low VIX?
A low Volatility Index implies that option prices are lower. This indicates that traders don’t expect much volatility in the market and are more confident with their positions. When the expected volatility is low, the sentiment is that stock prices will rise. When the VIX drops too low, it may be an indication of investor complacency and that we could be on the verge of a market reversal.
What Is a Normal VIX?
Although there’s technically no normal VIX value, there’s a level that’s generally considered to be normal. A level below 20 is largely viewed as a tranquil market, while a level above 30 is considered extremely volatile. Take note that these numbers aren’t cast in stone.
The Bottom Line
The CBOE Volatility Index, or VIX, is extremely useful in measuring market sentiment. Even so, it is not a perfect tool and should only be used to help you stay informed on the market mood and interpret implied market volatility when making your investments. And although you can’t invest directly in the VIX, you can invest in derivatives based on it or ETFs that track it.