The Volatility Index Explained for Dummies

 

What is the volatility index? 

  The Volatility Index, abbreviated as VIX, measures the expected volatility of the S&P 500 Index over the next 30 days.  The VIX is formally referred to as the Chicago Board Options Exchange (CBOE) Volatility Index. It is also commonly called the ‘fear gauge,’ the ‘fear index,’ or the ‘fear factor.’   

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Short history of the volatility index 

  In 1993, the Chicago Board Options Exchange (CBOE) created the VIX. The CBOE is the world’s largest stock exchange that concentrates on trading options.  The CBOE explains that the index was initially designed ‘to measure the market’s expectation of 30-day volatility implied by at-the-money S&P 100 Index option prices.’      In 2003, ten years later, the CBOE cooperated with Goldman Sachs (a global investment banking, securities, and investment management firm), and ‘updated the VIX Index to reflect a new way to measure expected volatility, one that continues to be widely used by financial theorists, risk managers, and volatility traders alike,’ according to a website of the CBOE. (Accentuation in the quotation is by the article writer.)    Since its update, the VIX Index is based on the S&P 500 Index (SPX). Also, futures were introduced for VIX trading in 2004, while options were introduced in 2006.   

Understanding the volatility index 

  As mentioned, the updated VIX is based on the S&P (short for Standard and Poor’s ) 500 which is the core index for U.S. equities. It is a stock market index that tracks the performances of the stocks of the 500 largest companies listed on stock markets (exchanges) in the USA.     Although the term volatility can have negative connotations, such as significant risks, considerable financial market declines, or uncertainty, it is in itself a neutral term. Simply put, volatility is a statistical measurement of price changes for securities or indexes. Greater volatility implies that a security or index is experiencing higher or lower price changes over short periods of time. In this regard, the CBOE explains that ‘the daily change in the VIX index is an indication of how aggressively SPX [S&P 500] contracts are being purchased or sold.’    The stronger the price changes, also called price fluctuations, the higher the volatility of a security.    In its definition of the VIX index, the CBOE refers to implied volatility, describing the index as follows: ‘The VIX index is an index of 30-day implied volatility as indicated by the prices of SPX option contracts.’ (Accentuation by the article writer.)    The CBOE explains implied volatility as follows:    

• Rising implied volatility 

Implied volatility rises when the relative prices of options move upwards, which is typically caused when the demand for options from buyers exceeds the supply of options from sellers.   

• Falling implied volatility 

Falling implied volatility occurs when the relative prices of options decline. This is the opposite of rising implied volatility when the supply of options from option sellers exceeds the demand for options from options buyers.    Why does the CBOE, as well as professional investors and financial analysts, describe the volatility as implied volatility? The gist of the term ‘implied volatility’ is that the VIX tracks the options market, where traders buy or sell options which are financial derivatives that allow the buyer the right (but not the obligation) to buy or sell the underlying security (for example stock) or index at a predetermined price within a specified time period.      Hence, as financial derivatives, the prices of options rely on the price movements of a security or index to reach a certain level. Regarding the VIX, it simply measures how expensive options are on the S&P 500 stock index. The prices of stock options fluctuate on a daily basis as the price of the underlying stock - or S&P 500 index - varies on a daily basis.     In practice, when the VIX rises, it is an indication that professional investors will respond to increased volatility in the S&P 500 in particular and stock markets in general. When the VIX declines, investors and traders are expecting smaller price fluctuations in the S&P 500 which implies steadier and calmer stock markets.    Price fluctuations of the S&P 500 and the VIX often indicate inverse price action, meaning when the S&P 500 declines sharply, the VIX rises, and vice versa.    The general theory about fluctuations of stock option prices is that the primary reason why prices rise, or decline is that investors expect that the future volatility of the stock market is moving up or down.     Stock Market MBA describes the theory as follows: ‘… if on average stock option prices go up or down, investors must be assuming that the stock market going forward is going to be more or less volatile. So, if the CBOE VIX index goes up, it ‘implies’ that the people buying the options must be assuming that the market going forward is going to be more volatile. It’s not a perfect theory - and thus the use of the term ‘implied volatility’ - but is generally correct.’ (Accentuation in the quotation is by the article writer.)     The VIX is also considered a reflection of investor sentiment.   Calculation of the VIX  Technically speaking, the VIX measures the expected volatility by using S&P 500 options, which are options that derive their prices from Standard & Poor’s 500.    Standard S&P 500 index (SPX) options - which expire on the third Friday of each month - and the weekly SPX options - which expire on all Fridays - are used to calculate the VIX values. The values of the SPX options must be present between 23 days and 37 days.    The calculation of the expected volatility is based on the call and put option prices of Standard and Poor’s 500 stocks. The weighted average prices of the S&P 500 puts and calls are aggregated over a wide range of strike prices. The midpoints of the bid and ask prices of options are considered to calculate the index.      Prices are weighted to determine whether investors and traders assume the S&P 500 index will gain or lose value over the next 30 days.    Basically, analysts and professional investors consider the following levels of the VIX as indicators of the extent of the volatility in the stock market: 

• Value of the VIX at 20 or lower: The market is considered to be in a phase of low volatility, implying stress-free periods of stability. 
•  Values between 20 and 30: Typically, an indication of high volatility. 
• Values greater than 30: Indicate periods of high abnormal high volatility, a sign that markets are very unsettled, resulting from high risk, investment fear, and increased uncertainty. 

  Bear in mind, that the VIX is a leading indicator which reflects investor sentiment. Hence, it should not be interpreted as an indication of an immediate market movement.      

How to use the volatility index 

  Traders and professional investors use various data sources and investment tools as part of their investment strategy. The VIX is a key tool to enable investors to understand when the stock market is possibly headed for big price movements - upwards or downwards.    Similar to other indices, when using the VIX, traders and investors are not investing directly in a security or index. Instead, they are applying the VIX to find the expected highs and lows. ‘When the high index indicates a downfall in the stock market when the VIX shows a significant increase, there will be some major change in the market, and it is the best time to act,’ according to WallStreetMajo.    The volatility index also affects the price of put options and call options, with both increasing. When the VIX is high, the higher premiums should be regarded to determine whether to keep the options or buy them.   

Criticism of the Volatility Index

  Financial analysts sometimes use the following arguments, amongst others, to criticise the volatility index: 

• The VIX mainly tracks price inverse, while the short time period of the prediction also narrows the prediction quality. 
• It is not based on historical data or statistical analysis. 
• The VIX indicates only implied volatility, implying it cannot predict volatility in case of abnormal conditions in the future, according the WallStreetMajo. 

  Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional, reputed, and regulated broker before making trading and investment decisions.  

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