THE VIX

VIX - CBOE Volatility Index

The Volatility Index, or VIX, is an index created by the Chicago Board Options Exchange (CBOE), which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities on S&P 500 index option. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk.

The VIX is often referred to as the "investor fear gauge."

Fear, volatility, and the index move up when stock prices are falling and investors are fearful. The index, volatility, and fear decline when stock prices are rising.

The VIX is referred to as an Exchange Traded Product (ETP)

Exchange-traded products (ETP) are a type of security that is derivatively priced and trades intra-day on a national securities exchange. ETPs are priced so the value is derived from other investment instruments, such as a commodity, a currency, a share price or an interest rate. Generally, ETPs are benchmarked to stocks, commodities or indices. They can also be actively managed funds. ETPs include exchange-traded funds (ETFs), exchange-traded vehicles (ETVs), exchange-traded notes (ETNs) and certificates.

How to construct the Index

Historically, the Chicago Board Options Exchange Volatility Index — or VIX for short — has been a bellwether benchmark for measuring the volatility of the U.S. financial markets.

Its formula is fairly simple:

Take a mathematical estimate of how investors believe the S&P 100 Index option (OEX) will move in the next year using a calculation based on the disparity between current OEX put and call option prices.

In that equation, the VIX rises when put option purchases move upward and declines when call option activity is robust.

In general, a “read” on the VIX is the result of that formula over a 30-day trading period.

A high VIX figure means traders fear a volatile market environment.

A low number signifies lower volatility — an environment most non-contrarian investors want to see.

In a research paper titled “Stock Market Volatility during the 2008 Financial Crisis” by Kiran Manda at the Stern School of Business, New York University, the takeaway is this: Market volatility has not gone away despite continued low volatility levels in the VIX in recent years...

Breaking Down 'VIX - CBOE Volatility Index'

The Volatility Index (VIX) led to two other volatility indexes being created. 

• The VXN, which tracks the NASDAQ 100. 
• The VXD, which tracks the Dow Jones Industrial Average (DJIA).

The VIX, however, was the first successful attempt at creating and implementing a volatility index. Introduced in 1993, it was originally a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Ten years later, in 2004, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors' expectations on future market volatility.

VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.

How the VIX's Value Is Established

The VIX is a computed index, much like the S&P 500 itself, although it is not derived based on stock prices. Instead, it uses the price of options on the S&P 500, and then estimates how volatile those options will be between the current date and the option's expiration date. The CBOE combines the price of multiple options and derives an aggregate value of volatility, which the index tracks.

The CBOE offers VIX options and VIX futures to trade. Additionally, there are many volatility indexes. One of the most popular, in terms of daily volume, is the iPath S&P 500 VIX Short-Term Futures ETN (VXX).

An Example of the VIX

Movements of the VIX are largely dependent on stock market reactions. When stock prices fall, the VIX will spike. The VIX typically moves much more than the stocks. For example, if stocks fall 3% in one day, the VIX may rise 15% or more.

The chart above shows how the S&P 500 and VIX interact. The moves in VIX can be severe, especially if a stock sell-off occurs when the VIX is at very low levels, such as below 15.

The sell-off in February saw the S&P 500 decline just under 12%. The VIX, during that time, rallied more than 350% before quickly pulling back once the stock market stabilized again.

The S&P 500 decline in March was less shocking to investors; the VIX moved up but much more conservatively, showing fear was at a much lower level relative to February.

So what is the Volatility Index Construction?

Developed by the Chicago Board Options Exchange in 1993, the CBOE Volatility Index (Chicago Options: ^VIX) often referred to as the "investor fear gauge," because of its representation of investors predictions on the market's volatility. 

Using short-term near-the-money call and put options, the index measures the implied volatility of S&P 500 index options over the next 30 day period. But because it's basically a derivative of a derivative, it acts more like a market thermometer.