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Understanding VIX or Volatility Index
Did you know that there's a way to measure the expected volatility of the stock market? The VIX or Volatility Index allows you to do just that. It is one of the most recognized indicators of expected market volatility and is widely followed as a daily market indicator.
What is volatility?
Volatility reflects the amount of risk related to fluctuations in a security's value. It is measured using the variance between returns from a security or index. A highly volatile security can see its price change dramatically in either direction over a short period of time. On the other hand, a security with low volatility will tend to hold its price over time.
There are three main types of volatility – Standard Deviation, Beta and Implied Volatility.
Standard Deviation: This measures changes in a security’s price over a specific period.
Beta (β): This measures a security’s volatility in relation to the market. A security with a beta that’s higher than 1.0 is seen as more volatile than the market.
Implied Volatility: Also known as projected volatility, it is calculated from option prices and is used to estimate future fluctuations in a security's price.
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What is the Chicago Board Options Exchange (CBOE) Volatility Index?
The Chicago Board Option Exchange(CBOE) Volatility Index was introduced by Cboe Global Markets, Incorporated (Cboe) in 1993. Simply referred to as 'the VIX', it is a market index that measures the implied volatility of the S&P 500 Index (SPX) – the core index for U.S. equities. In real-time, it represents the market’s expectations for volatility over the coming 30 days. Today, investors use the VIX to get an understanding of market risk as well as investor sentiment.
How VIX works
The Volatility Index or VIX is the annualized implied volatility of a hypothetical S&P 500 stock option with 30 days to expiration. The price of this option is based on the prices of near-term S&P 500 options traded on CBOE.
It can help investors estimate how much the S&P 500 Index will fluctuate in the next 30 days.
While the VIX only measures the volatility of the S&P 500 Index, it has become a benchmark for the U.S. stock market.
The VIX is often referred to as the market’s “fear index or fear gauge”. The performance of the VIX is inversely related to the S&P 500 – when the price of the VIX goes up, the price of the S&P 500 usually goes down.
If the VIX is rising, demand for options is increasing, and therefore, becoming more expensive. If the VIX is falling, there's less demand, and options prices tend to fall. One thing to keep in mind is that current volatility cannot be known ahead of time. That's why it's a good idea to use the VIX in tandem with technical and fundamental analysis.
Calculating VIX values
The calculation of the VIX is as follows:
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Start by selecting the options to be included in the calculation. It should include a range of call and put strikes in two consecutive expirations around the target 30-day mark.
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Next, calculate the contribution of each option to the total variance of its expiration.
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Get the total variances of the first and second expiration by summing up the contributions.
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Then calculate the 30-day variance by interpolating the two variances, depending on the time to expiration of each.
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Take the square root to get volatility as standard deviation. Then simply multiply the volatility (standard deviation) by 100.
The result is the VIX index value.
How the VIX Index is used
The VIX can help investors gauge market sentiment as well as volatility to identify investment opportunities. As volatility can often signal negative stock market performance, volatility investments can be used to speculate and hedge risk.
This knowledge can be used to make informed investment decisions. Typically, when the price of VIX is:
0-15: This can indicate a certain amount of optimism in the market as well as very low volatility.
15-25: This can indicate that there is a certain amount of volatility, but nothing extreme.
25-30: This can indicate that there is a certain amount of market turbulence and volatility is increasing.
30 and over: This can indicate that the market is highly volatile and there may be some extreme swings soon.
And because the VIX is an index, it can be tracked as well as traded using a variety of options and exchange-traded products. Investors also have the option to use VIX values to price derivatives.
You cannot purchase the VIX like a stock or bond. Instead, you must purchase instruments that respond to fluctuations of the VIX. Traders can place their hedges through VIX options and futures.
There are also nearly two-dozen volatility exchange-traded products (ETPs) for the VIX. This includes both exchange-traded funds (ETFs) that hold assets and exchange-traded notes (ETNs).
Volatility Index FAQs
What are high and low VIX numbers?
Generally, VIX values that are greater than 30 can signal heightened volatility from factors like investor fear and increased uncertainty. On the other hand, VIX values that are lower than 20 can signal increased stability in the markets.
Is it a good sign when the VIX is down?
The VIX tends to move in the opposite direction of the market. When the VIX is up it can mean that there is increased fear and risk in the market. Conversely, when the VIX is down it can mean that there is more stability in the market.
Is there a VIX Index in Canada?
Yes, there is a VIX Index in Canada. The S&P/TSX 60 VIX Index measures the 30-day implied volatility of the Canadian stock market. It is represented by the S&P/TSX 60 ETF (XIU), which uses options on the ETF.
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