What is the CBOE Volatility Index (VIX)?
The CBOE Volatility Index (VIX), created by the Chicago Board Options Exchange, is an indicator that can help investors gauge how volatile the stock market may be in the near term.
🤔 Understanding the CBOE Volatility Index (VIX)
The VIX helps measure the volatility of the stock market. It is sometimes called the fear index. It helps investors figure out the level of fear or optimism in the market. If people are too optimistic or fearful, there is a good chance that the market will behave erratically. When the VIX gets higher, there is more fear. The Chicago Board Options Exchange (CBOE) calculates the VIX. The CBOE uses options prices from the S&P 500 index to calculate it. A stock option is an agreement that gives the owner the right — but not the obligation — to buy or sell a stock. For international stocks, there is the CBOE EFA ETF Volatility Index.
Imagine an investor looking to buy stocks. If the VIX is high, he knows that there is likely to be more volatility in the market. This could indicate that rapid changes in stock prices are coming soon, potentially leading to buying opportunities.
The VIX is like a weather report…
If rain concerns you, you can check the weather report to find the best time to go out. The VIX is similar. If you're concerned about when to invest, you could check the VIX to see what other investors think the stock-market weather will look like in the near term.
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What is the CBOE Volatility Index (VIX)?
The Chicago Board Options Exchange created the CBOE Volatility Index. It is a volatility index that provides an estimate of volatility over the next 30 days. It measures market risk and investor sentiment. Investor sentiment is the general feeling of investors towards the market.
Prices of S&P 500 index options provide the basis for the VIX. Buyers and sellers determine option prices. If there are more buyers, option premiums go up. If there are more sellers, option premiums go own. An option premium is the current price of an option contract.
The average of these prices provides CBOE the information to calculate the VIX. It gives us a sense of what investors want to pay for the right to buy or sell the S&P 500 index. The VIX allows us to determine if there is too much optimism or fear in the market. When investor sentiment goes to an extreme, the market may reverse course. In general, if the VIX goes above 30, then investors consider the market volatile. When it goes below 20, investors consider it calm.
How does the VIX work?
The VIX rises when more investors are buying put options on the S&P 500. It falls when more investors are buying call options on the S&P 500 index. Put and call options give the buyer the right, but not the obligation, to sell stock and buy shares at specific prices during a specified period.
Generally, more market volatility will lead to higher option prices (called the ‘premium’). If the market is calm, then option premiums will be lower. When the market is quiet, there are more investors buying call options. The calmness speaks to a lack of fear. When the market is very volatile, there are more investors purchasing put options. The volatility reflects fear. So, a rising VIX implies that investors assume the S&P 500 index may become more volatile. A falling VIX means that investors believe the S&P 500 index will become calmer.
What does the VIX measure?
The VIX measures expected volatility or price movements of options on stocks in the S&P 500 index. Investors use the VIX as an indicator of uncertainty in the market. It helps investors predict future market volatility in the S&P 500. It reflects prices that investors are willing to pay for call or put options.
Investors may interpret the options prices as the degree of risk in the market. If there is more risk, more people are likely to buy options. When option premiums go down, the VIX does as well. The VIX reflects investor sentiment. It doesn't directly measure volatility –- It measures the market’s expectations of volatility.
How is the VIX calculated?
Option prices are part of the VIX calculation, but the CBOE does not use an option pricing model. CBOE uses a formula that looks at the variance of options prices with the same date of expiration. To calculate the VIX, CBOE selects options for the index. It includes a series of call and put strikes in two successive expiration dates. Then the CBOE will calculate each option's influence on the total variance.
CBOE will then calculate the total variance for the first and second expiration date. They then calculate the 30-day variance by interpolating the two variances. The standard deviation is the square root of the 30-day variance. The CBOE multiplies that standard deviation by 100 to get the VIX.
Why is the VIX important?
The VIX is important to both traders and investors. The higher the VIX, the higher the expectation that stocks will move fast. For traders, the high VIX implies higher option prices. For investors, it can help predict market movements. The VIX tends to rise when the market is going down and declines when the market is going up.
Value investors can use a higher VIX to find good companies whose shares may have dropped. For other investors, the VIX can be a bearish sign. If the VIX is rapidly increasing, it could be a sign to steer clear of the market. Traders may short the market when the VIX is rising. By using the VIX, traders and investors can get a better gauge of investor sentiment or the mood of the market.
What is a normal VIX value?
While there is no "normal” VIX value, there is a range that traders can consider. A VIX level below 20 is commonly considered a calm market. A VIX above 30 is widely considered a volatile market. However, these numbers are not set in stone.
What does a low VIX mean?
A low VIX typically means that option prices are lower. Traders are not as likely to be buying insurance on stocks. They do not expect a lot of volatility in the markets and feel more confident. When they expect low volatility, they also assume rising stock prices.
The VIX is an indicator. If the VIX gets too low, it may indicate that investors are too complacent, and a reverse in the market may occur. But this doesn't happen all the time. The VIX isn't a perfect tool. It is only one tool for investors to stay informed on market sentiment.
You can never predict the direction that a stock’s price will move, nor the direction of the overall market. All investments carry risk.
How to trade the VIX?
There is no way to invest directly in the VIX, but there are securities that you can invest in that aim to mimic the VIX. First, there are futures contracts. Traders can buy futures contracts based on the VIX. There are also index options based on the VIX that traders can access.
Also, there are Exchange-Traded Notes (ETNs) based on the VIX. These are like Exchange-Traded Funds (ETFs). The main difference is that they are debt notes issued through a fund company. If a trader wants to bet on rising volatility, they could invest in an ETN that reflects returns on the VIX.
There are also ETF products that reflect futures contracts on the CBOE Volatility Index.
If an investor wants to bet on volatility falling, they could invest in an inverse ETN. This would track an inverse index of futures contracts on the CBOE Volatility Index.
All investments carry risk. Always keep your investing goals, and tolerance for risk, in mind.
Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risks. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com/about/publications/character-risks.jsp. Investors should consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.
Leveraged and inverse ETFs are not suitable for most investors. These products represent unique risks, including leverage, derivatives, and complex investment strategies. They are designed for daily use only, and not intended to be held overnight. For more information, please read this guidance from FINRA.
Exchange-traded notes (ETNs) are not exchange-traded funds (ETFs); ETNs have characteristics and risks which are different from ETFs. An ETN promises to pay at maturity, the full value of the index, minus the management fee. Like any other debt security, the investor is subject to the credit risk of the bank issuer.
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