Known as the Fear Index, the VIX is a phenomenal indicator of the mood of US stock market investors. In this post we will see about what the VIX is, how it is calculated, and how we can use it to take investment decisions.
Content
- What is the VIX index
- Why volatility matters
- How the VIX index is calculated
- How to interpret the VIX
- Different VIX levels and fear they indicate
- Invest in the VIX
What is the VIX index
The VIX, short for Volatility Index, was introduced in 1989 and has become very popular over the last few decades as the Fear Index in the US stock market.
The VIX is calculated by the CBOE exchange in Chicago, where financial options are traded. Options give the right, without the obligation, to buy or sell a certain stock or stock index in the future, at a pre-determined price.
Thus, the VIX index measures the volatility that is expected in the US stock market for the next 30 days. The US stock market is, by far, the largest in the world, so it will move all other stock markets with it.
Higher expected volatility means that movements in the stock market are expected. And, because downward movements are typically faster and more pronounced than upward movements, the VIX is used to gauge how likely a stock market crash is, according to investors.
A rise in the VIX means that market investors believe that the probability of large drops has increased. Consequently, the index can be used to interpret how much fear there is in the stock market.
Why volatility matters
One of the determining factors when calculating the price of a financial option is its implied volatility. Because options give to their owners the unilateral right to buy or sell an asset at a specific price, they benefit from elevated volatility.
After all, if we have an option, the worst that can happen is that we lose all the money we have paid for it. Our losses are therefore limited.
However, if the price of the asset that we can buy or sell at a certain price moves dramatically in our favor, we can multiply our investment many times. The return can be enormous.
That asymmetry between limited losses and unlimited profits makes volatility a very positive thing for options.
And implied volatility is nothing more than the volatility expected by investors in the options market. The higher the implied volatility, the greater movements are expected.
If you want to learn the most important facts about options, you can take a look at this link:
Financial Options
How the VIX index is calculated
Now let us talk about how the VIX index is calculated. We have already said that it serves to measure the expected volatility for the US stock market in the next 30 days.
To measure that implied volatility, call and put options on the S&P 500 stock market index are used. The S&P 500 index measures the performance of the top 500 companies in the United States. As a result, it is the best gauge to determine if the US stock market is going up or down.
The options used for the calculation of the VIX have maturities of between 23 and 37 days, so they are representative of what is expected in the next 30 days.
The options that are used are all out of the money. This means that the call options used have a strike price higher than the current value of the S&P 500. While the put options used have a strike price that is lower than the current value of the S&P 500.
Options at different strike levels are used. The strike is simply the price at which the option allows us to buy or sell the underlying asset, in this case the S&P 500.
Let us imagine that the S&P 500 trades at 4,000 points. In that case, the call options used to calculate the VIX would give us the right to buy the S&P 500 at prices between 4,020 and 4,400 points.
On the other hand, the put options used, which would give us the right to sell the S&P 500, would have strike prices of between 3,600 and 3,980 points.
Once we have all these options, both put and call, with maturities of between 23 and 37 days, and with strikes close to the value of the S&P 500 but out of the money, we look at the implied volatility of all of them.
Finally, the CBOE weights the implied volatilities of all these options, with a highly complex formula, and then annualizes that expected volatility. The exact formula used by the CBOE can be found here.
The result of all these calculations is the VIX index. And the CBOE publishes it in real time. So we can know at all times how much volatility the market expects. In other words, we can know in real time how much fear there is in the US stock market.
How to interpret the VIX index
We have already discussed that the VIX indicates the level of implied volatility in options on the S&P 500. Implied volatility basically means expected volatility.
As a result, the VIX should not be interpreted as the volatility that will necessarily occur in the stock market. Rather, it is the volatility that stock market investors expect. And, very often, investors are wrong.
The VIX can be used in two ways. The first is as a tool to measure how much fear there is in the market. And that fear may be justified. So, in theory, a higher value for the VIX should make us more prudent.
The second is as a contrarian indicator. Since investors are unable to predict the future, they can also be wrong about what will happen. In fact, the level of optimism in the stock market is highest when stock prices are high, and lowest when stock prices are low.
A very low value for the VIX indicates a lack of fear. In other words, plenty of optimism. And it is precisely at that moment when a crash is most likely to occur. Since everyone who wanted to invest in stocks, is already invested, there is no additional demand to push stock prices higher.
On the contrary, a very high value for the VIX indicates extreme panic, and that most investors are pessimistic. This means that everyone has already sold. If there is no additional sellers, prices can only go in one direction: higher.
Something very interesting is that the highest values experienced by the VIX throughout history have occurred precisely when the market had already fallen by 30-50%. And, statistically speaking, it is highly unlikely that there will be big declines when the market has already plummeted so much. This would validate the contrarian indicator approach.
Different VIX levels and fear they indicate
Let us see what different VIX values mean. Keep in mind that the values used to build these bands are approximate:
- Less than 12: If the VIX index is below 12, the expected volatility is very low and there is very little fear. If it were to fall below 10, we might even speak of too much complacency. We must be cautious when that happens.
- 12 to 20: these are normal values, which indicate that there are both optimistic and pessimistic investors.
- 20 to 30: The VIX is high, indicating that there is a significant number of pessimistic investors. That means something bad can happen, but that fear may not be justified.
- More than 30: values above 30 indicate a lot of fear in the market. We can even speak of panic above 40. And at higher values, of 60 or even 80, investors are expecting the end of the world. Interestingly, when we see these extreme value, we will most likely find ourselves in the middle of the crash, so it can be a great time to buy stocks.
Invest in the VIX
Finally, and for those who want to consider investing directly in the VIX index, it should be noted that it is possible to do so through an ETF.
If we expect a sudden rise in implied volatility, we can invest in an ETF that tracks the VIX. However, you should keep in mind that VIX ETFs represent a synthetic option that can never be executed, so, in the medium and long term, its price will fall no matter what.
This is because options lose value as time goes on, and these ETFs represent a perpetual option.
The only option we have to make money with a VIX ETF is to sell it shortly after buying it, after there has been a rise in the VIX. If we time it well, we can make large profits.
For reference, you can check out the VXX ETF fund, managed by Barclays, and see its long-term historical price. It tends to go down over time, with sudden spikes when implied volatility jumps.
I hope you found this explanation of the VIX helpful. As always, I encourage you to learn as much as possible. Especially when it comes to highly complex investments.
Given the VIX index is based on options, it is a highly complex derivative instrument.
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