VIX Explained
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In the last month, major stock indexes like the S&P 500 have been pulled downward as a result of disappointing earnings reports from big tech stocks. If you've been following financial news, you may have heard the word "volatility" being thrown around a lot — and you may have heard a reference to a volatility measurement called the VIX.
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What is VIX?
VIX is the ticker symbol for the Cboe Volatility Index, which is widely used by investors to anticipate future market volatility. Sometimes referred to as the “fear index,” VIX is a reflection of investor uncertainty and expected future price fluctuations across the broader financial market. The VIX index was introduced in 1993 by the Chicago Board Options Exchange, which has since been abbreviated to Cboe.
The VIX index attempts to measure how much volatility the S&P 500 index will experience over the next 30 days. The word “volatility” is often associated with something bad from an investor standpoint, but VIX is simply measuring a range of how much price movement investors should anticipate — which could be up or down. In order to calculate this expected price movement, the VIX index measures implied volatility by averaging weighted prices of options trading for the S&P 500.
The basics of VIX
The VIX index was introduced by the Chicago Board Options Exchange, or Cboe, as a way for investors to measure future price volatility for the S&P 500 index.
To measure future volatility, the VIX index uses the weighted prices of the S&P 500 index (SPX) options trading.
The prices used to calculate the price of the VIX are midpoints of real-time S&P 500 option bid/ask price quotations, according to Cboe.
As investor uncertainty increases, the price of the VIX increases correspondingly.
How is VIX calculated?
The formula used by Cboe to calculate the price of VIX is rather complex, and the price of VIX is updated live during trading hours every 15 seconds. To spare you the math headache involved with calculating the price, let’s look instead at the data used to calculate it. The VIX index is specifically measuring expected volatility for another index, the S&P 500. True to its name, the S&P 500 index is composed of 500 of the largest publicly traded companies in the U.S. Because the S&P 500 includes so many large companies across several different market sectors, it is generally viewed as a good indication of how the U.S. stock market is performing overall.
» Learn more: What is the S&P 500?
When investors trade options, they are essentially placing bets on where they think the price of a specific security will go. In many cases, large institutional investors will use options trading to hedge their current positions. So, if the big firms on Wall Street are anticipating an upswing or downswing in the broader market, they may try to hedge against that volatility by placing options trades. If many of the large investment firms are anticipating the same thing, there is usually a spike in options trading for the S&P 500. The VIX index uses the bid/ask prices of options trading for the S&P 500 index in order to gauge investor sentiment for the larger financial market.
VIX and volatility
As the range of strike prices for puts and calls on the S&P 500 increases, it indicates that the investors placing the options trades are predicting some price movement up or down. Typically, the performance of the VIX index and the S&P 500 are inversely related to each other. In other words, when the price of VIX is going up, the price of the S&P 500 is usually heading south.
Understanding how the VIX index is calculated can help investors gauge market sentiment based on its price. The price of VIX can guide your decision making on when to buy or sell securities. As a general rule, when the price of VIX is:
$0-15, this usually indicates optimism in the market and very low volatility.
$15-25, there is typically a moderate amount of volatility, but nothing extreme. VIX prices in this range are indicative of a normal market environment.
$25-30 indicates some market turbulence, that volatility is increasing and investor confidence is likely waning.
$30 and over — buckle up! VIX prices over $30 typically indicate some extreme swings in the market coming up.
Increasing VIX prices accompanied with downturns in the larger market have taken place very recently. Here’s a look at the last decade:
Can I buy VIX?
Investors cannot buy VIX directly, as it is merely an index used for market analysis. However, there are a wide array of exchange-traded funds, or ETFs, and exchange-traded notes — or ETNs — tied to the VIX index that are available for purchase. Given that the performance of VIX is negatively correlated to the S&P 500, some investors choose to buy ETFs or ETNs linked to the VIX as a way to diversify their holdings and hedge against other positions in their portfolio. It’s important to note that the VIX itself can be exceedingly volatile. VIX lost about 54% of its value between March and July of 2020 while the S&P 500 recovered from the pandemic.
Before purchasing a security tied to an index like the VIX, it’s important to understand all of your options so that you can make educated decisions about your investment choices. If you’re interested in investing in a VIX ETF/ETN, we recommend that you speak with a financial professional first to make sure your investment strategy fits your needs.
