What is the VIX?
The Chicago Board Options Exchange (CBOE) created the VIX (CBOE Volatility Index) to measure the 30-day expected volatility of the US stock market, sometimes called the “fear index.” The VIX is based on the prices of option premiums on the S&P 500 and is calculated by aggregating weighted prices of the index’s call and put options over a wide range of strike prices.
Volatility measures the frequency and magnitude of price movements over time. The more substantial the price change, the greater the volatility. It can be measured with historical values or expected future prices. The index is a measure of expected future volatility.
The VIX is intended to be used as a market indicator of uncertainty by providing market participants and observers with a measure of the volatility of the US stock market. The index is forward-looking in that it seeks to predict variability of future market movements.
The fact that the index represents expected volatility is very important. It is based on the premiums that investors are willing to pay for the right to buy or sell a stock, and not actual volatility. The premiums for options can be seen as a risk. The greater the risk, the more people are willing to pay for insurance. When premium on options falls, so does the VIX.
Uses of the VIX Volatility Index
The VIX is given as a percentage, representing the expected movement range over the next year for the S&P 500, at a 68% confidence interval. In the above graph, the volatility index is quoted at 13.77%. It means that the annualized upward or downward change of the S&P 500 is expected to be less than 13.77% within the next year with a 68% probability.
The monthly, weekly, or daily expected volatility can be calculated from the annual expected volatility. There are 12 months, 52 weeks, or 252 trading days in a year. By using the annual expected volatility of 13.77% from above, the calculations are:
A high VIX would indicate high expected volatility and a low VIX would indicate low expected volatility.
Although a high index would indicate high expected volatility in either direction, it is still perceived volatility. When investors anticipate large upswings or downswings of their stocks, they will protect their positions with options. Investors are unwilling to sell their call or put options unless a large premium is paid. Therefore, the aggregate increase in call or put option prices will raise the index and would indicate to market participants the market will move sharply in either direction.
The VIX is a good indicator in that it gives a current and accurate measure of where options in the S&P 500 is trading at.
History of the VIX
The long-term average for the VIX volatility index is 18.47% (as of 2018).
Historically speaking, a VIX of below 20% reflects a healthy and low-risk market. However, if the volatility index is too low, it implies a bullish view on the market. If everyone’s bullish, there will be no buyers left eventually and the market will come crashing down.
A VIX of greater than 20% signifies fear is entering the market and implies a high-risk environment. During the 2008 housing crisis, the volatility index skyrocketed to extreme levels of above 50%. It means investors expected stock prices to fluctuate between a 50% upswing or downswing within the next year, 68% of the time. At one point, the index reached 85%.
Although VIX levels are very high during times of crisis, extreme levels cannot be sustained as the volatility index is driven by perception and fear during said periods of time.
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