The CBOE Volatility Index (VIX): What It Is and How to Use It
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Summary:
The CBOE volatility index (VIX) is a measure of market volatility that is calculated based on the prices of S&P 500 options. The VIX predicts expected volatility over the next 30 days and measures the level of fear or uncertainty in the market.
If you’re interested in investing in the stock market, one of the best steps to take is to become familiar with market indexes. One of the most widely followed metrics in the stock market, sometimes referred to as the “fear index,” is the CBOE volatility index.
But what exactly is the VIX, and how does it work? In this article, we’ll take a closer look at the VIX, its calculation, and how it can be used as a tool for investors.
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What is the VIX?
The CBOE volatility index (VIX) is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Back in 1993, the Chicago Board Options Exchange (CBOE) introduced VIX as a way to gauge market sentiment and provide investors with an indication of the level of fear or uncertainty in the market.
Many investors refer to the VIX as the “fear index” because it tends to rise when investors feel nervous or uncertain about the market. Conversely, the VIX tends to fall when investors feel more confident and optimistic. As such, the VIX can be a useful tool for traders and investors who want to get a sense of the overall mood of the market.
How is the VIX calculated?
The VIX is calculated using the prices of S&P 500 index options. These stock options are contracts that give the holder the right to buy or sell the underlying S&P 500 index at the strike price on or before the expiration date.
To calculate the VIX, the CBOE uses a mathematical formula that takes into account the prices of a range of S&P 500 options with different strike prices and expiration dates. The formula looks at the prices of both calls and puts and weighs each option price based on its proximity to the current market price of the S&P 500.
The resulting number is an estimate of the expected volatility of the S&P 500 over the next 30 days. For example, if the VIX is currently at 20, it means that the market is expected to be more volatile over the next 30 days than if the VIX were at 15.
IMPORTANT! It’s worth noting that the VIX isn’t based on actual volatility, but rather on the market’s expectation of future volatility. This means that the VIX can sometimes be an imperfect predictor of actual market volatility, especially in times of extreme market stress.
What does the index measure?
The VIX measures the market’s expectation of near-term volatility in the S&P 500 index. Specifically, it’s designed to represent the expected annualized change in the S&P 500 index over the next 30 days based on the prices of S&P 500 options.
Investors often use the VIX as a gauge of fear or uncertainty in the market. When the VIX is high, it indicates that traders and investors expect large price swings in the S&P 500 over the next 30 days, which can be a sign of fear or uncertainty. Conversely, when the VIX is low, it indicates that traders and investors aren’t expecting large price swings, which can be a sign of confidence or complacency.
While the VIX is designed to measure volatility in the S&P 500, it’s also used as a proxy for overall market volatility. This is because the S&P 500 is widely regarded as a benchmark for the broader market, and many other stock market indices tend to move in a similar direction to the S&P 500. As such, changes in the VIX can be an indication of changes in overall market sentiment.
How do you read the VIX CBOE?
The VIX is expressed as a percentage and reflects the expected annualized change in the S&P 500 index over the next 30 days. For example, a VIX reading of 20 indicates that the market is expected to move up or down by 20% over the next year. Alternatively, it could move around 1.25% over the next 30 days.
Uses and limitations of the VIX
The VIX can be a useful tool for investors who want to gain insights into the overall mood of the market and make informed investment decisions. However, it’s not the right tool for every situation. Before relying on the index too heavily, make sure you consider the advantages and disadvantages of using the VIX.
Uses explained
- Gauge market sentiment. If the VIX rises, it can indicate that traders and investors are more fearful or uncertain about the market. Conversely, if the VIX falls, it can indicate that traders and investors feel more confident and optimistic.
- Manage risk. Investors can use the VIX to help manage risk in their portfolios. If the VIX rises, it may be a good time to consider reducing exposure to riskier assets, such as stocks. Conversely, if the VIX drops, it may be a good time to consider increasing exposure to riskier assets.
- Time entries and exits. Though not the only index to use for this idea, you can also use the VIX to time entries and exits in the market. For example, if the VIX is high and an investor wants to buy a stock, it may be better to wait for the VIX to come down before making a purchase. Similarly, if the VIX is low and an investor wishes to sell a stock, it may be a good time to consider taking profits.
- Use VIX derivatives. Finally, investors can use VIX derivatives, such as VIX futures or options, to gain exposure to market volatility or hedge against volatility in their portfolios. These instruments allow investors to make bets on the direction of the VIX, or to protect their portfolios against adverse moves in the VIX. However, it’s worth noting that VIX derivatives can be complex and may not be suitable for all investors.
Limitations explained
- Forward-looking indicator. The VIX is based on the prices of S&P 500 options, which are themselves forward-looking indicators. This means that the VIX is also a forward-looking indicator and may not always accurately predict what happens in the market.
- Doesn’t predict magnitude. The VIX only predicts the direction and magnitude of expected volatility, not the actual magnitude of the price changes. This means that a high VIX reading doesn’t necessarily mean that the market will experience a large decline, it only means that the market may be more volatile.
- Short-term indicator. The VIX is designed to predict volatility over the next 30 days. This means that it may not be as useful for investors who want to make longer-term investment decisions.
- Not the only indicator. While the VIX can be a useful indicator of market sentiment and risk, it should not be the only indicator you rely on. Investors should also consider other indicators, such as economic data, corporate earnings, and market trends when making investment decisions.
- Subject to manipulation. Like any financial indicator, the VIX is subject to manipulation. While the CBOE takes steps to prevent manipulation, it’s still possible for traders to try to influence VIX levels through trades in S&P 500 options.
Overall, while the VIX can be a valuable tool for investors, it’s important to keep its limitations in mind and to use it in conjunction with other indicators and investment strategies.
Key Takeaways
- The CBOE volatility index (VIX) measures the expected volatility of the S&P 500 index over the next 30 days.
- The VIX is calculated based on the prices of S&P 500 options.
- Though this index can be helpful, it should not be the only indicator investors rely on.
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