VIX: Understanding the Market Volatility Index

July 26, 2022

A classic Wall Street mantra goes: the VIX is high, it’s time to buy, the VIX is low, look out below.

Some may remember the “Short the VIX” meme going around financial social media in 2018, but what does that mean? And how do investors know how to utilize the VIX to their advantage?

What Is the CBOE Volatility Index (VIX)?

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is one of the most common tools used as a barometer of market sentiment. The VIX is a real-time volatility index that represents Wall Street’s expectations for near-term price changes in the S&P 500 index (SPX).

The VIX was the first benchmark to quantify market expectations of volatility, introduced in 1993. The index is forward-looking, meaning that it only shows the implied volatility of the S&P 500 for the next 30 days. Because it is derived from the prices of SPX index options with near-term expiration dates, it generates a 30-day forward projection of volatility.

How does the VIX Work?

The VIX measures the degree by which prices are moving in the S&P 500, aka its volatility. The larger the price swings, the higher the VIX index will be. While the VIX is an index used to measure market sentiment and expected volatility, investors can also trade VIX futures, options, or ETFs to hedge or speculate on future volatility changes.

Due to the popularity of the VIX, the CBOE now offers several other versions for measuring broad market volatility including the CBOE Short-Term Volatility Index (VIX9D), the CBOE S&P 500 3-Month Volatility Index (VIX3M), and the CBOE S&P 500 6-Month Volatility Index (VIX6M), which measures the expected nine-day, 3-month, and 6-month volatility respectively.

Volatility metrics have also sprung up for other market indexes including the Nasdaq-100 Volatility Index (VXN), the CBOE Dow Jones Industrial Average Volatility Index (VXD), and the CBOE Russell 2000 Volatility Index (RVX).

Calculation of VIX Values

The VIX is calculated using the live prices of SPX index options, expressed as a percentage. To be considered for the VIX index, an option must have an expiry date between 23 and 37 days.

The actual calculation of the VIX involves some pretty complicated mathematics (take a look at the formula here), but that isn’t necessary for every investor to understand in order to understand the impact of the VIX.

The basic theory of the calculation is that by combining the weighted prices of multiple SPX put and call options over a wide range of strike prices, you can gain insight into what prices traders are willing to buy and sell the S&P at. The final values estimate the future volatility of the S&P 500.

What Does the VIX Indicate?

If the VIX value increases, it is likely that the S&P 500 is falling, while if the VIX declines, the S&P 500 is likely to be stable in the near future.

Historical data shows a strong negative correlation between volatility and stock market returns, meaning that when stock returns fall, volatility rises, and vice versa.

The VIX signals the level of stress or fear in the U.S. stock market by using price swings in the S&P 500 as a proxy for the broad market. The VIX is commonly known as the “Fear Index” or “Fear Gauge” as a higher level of the VIX indicates a greater level of fear in the market, which can indicate a potential bear market.

The VIX is thought to predict tops and bottoms in the market: as the VIX reaches significant highs, traders see this as a sign of impending bullish pressure on the S&P 500, and if the VIX reaches lows, its viewed as bearish for the S&P 500.

What is a Normal Value for the VIX?

The long-run average of the VIX has been around 21. In recent years, a VIX value below 20 has indicated market stability while levels of 30 or more have indicated high volatility.

How to Trade Volatility

Like any other index, the VIX cannot be bought directly. Instead, it can be traded through futures contracts, exchange-traded funds (ETFs), or exchange-traded notes (ETNs) that own futures contracts. CBOE launched the first VIX-based exchange-traded futures contract in March 2004, then launched VIX options in February 2006.

VIX-linked financial instruments allow traders to gain pure volatility exposure, allowing volatility to act as a new tradable asset class. Active traders, institutional investors, and fund managers use VIX-linked securities for portfolio diversification and as a hedge for market downturns. Active traders also use VIX values to price out derivatives.

Going Long on Volatility

When you open a position on the VIX, the two basic positions you can take are going long or short. The position you take depends on your speculation about the future volatility levels. Traders who go long on the VIX believe that volatility is going to increase and the value of the VIX will increase with it.

Going long on the VIX is a popular position in times of market instability. For example, if a trader believes the S&P 500 was going to experience a rapid decline, they might take a long view of volatility and may trade that by opening a position to buy the VIX.

Shorting Volatility

When a trader takes a short position on the VIX, it is likely because they expect the S&P 500 to rise in value. Short-selling volatility is popular when interest rates are low and the economy has been in a stable bull market. In these situations, investors may believe the stock market will continue to rise and volatility will remain low.

If the S&P 500 does rise, the VIX is likely to move lower, and traders who shorted the VIX would profit. However, shorting, in general, comes with inherent risk as there is the potential for unlimited loss if volatility spikes.

The Bottom Line 

The VIX is the most popular metric for expected market volatility and is often used to indicate economic sentiment. It tends to rise during times of market stress, which makes it an effective hedging tool for active traders. 

In general, VIX values of greater than 30 are considered to signal heightened volatility from increased uncertainty, risk and investor fear. VIX values below 20 generally correspond to more stable, less stressful periods in the markets. 

This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied upon to form the basis of an investment decision. 

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