In the United States, The Chicago Board Options Exchange (CBOE)’s Volatility Index (VIX) is the most popular measure of share market volatility. Because it measures the prices of options over the S&P 500, investors often refer to it as the “fear index” or “fear gauge.” Whether optimistic or fearful, investors worldwide look to the VIX as a significant indicator of the market volatility.
Market volatility: a bumpy ride
Before delving into the particulars of the VIX, it is necessary to know what volatility is. In the market, volatility is a measure of the size and frequency of movements—prices of shares or the levels of indexes. Investors use volatility to figure an index’s trading range within different probabilities. Volatility is expressed in mathematical terms as the annualized standard deviation of daily percentage changes in a security’s share price or index level.
For example, an index trading at 1000 points with a volatility of 25% would have:
A 68.3% chance of the index being between 750 and 1250 points (that is, one standard deviation above or below its start) after one year, and a 95.4% chance that the index will be between 500 and 1500 points (two standard deviations up or down) after one year.
Volatility figures can also be used to find a likely trading range over a short span of time. By making use of volatility’s proportionality to the square root of time, you can find probable trading ranges for spans of time less than a year by following a set formula.
Implied volatility: what investors think will happen next
The quote of an option on the market is partially based upon a volatility assumption called the “implied volatility.” This figure exists to represent the market’s forecast of an index’s or stock’s volatility over time (that is, the life of the option). Models pricing the options market must use these forecasted numbers in order to match option values with their current market price.
Just what is the VIX?
After covering what volatility is—and how it affects market pricing—we can return again to the VIX. Introduced in 1993 by the Chicago Board Options Exchange (CBOE), it measures the 30-day expectation of market volatility as implied by index option prices.
At its inception, the VIX was made from the implied volatilities of eight different at-the-money option series (that is, calls and puts) over the S&P 100 index. This was meant to make the VIX a representation of the implied volatility of a hypothetical at-the-money option over the S&P 100 with 30 days to expiration. Looking at only 100 stocks, however, was not enough, so in 2003 the VIX was modified to be calculated from prices of options over the S&P 500 Index—allowing for the VIX to use a greater number of option series in its calculation. Now, forecasted volatility is found by averaging the weighted prices of options over a range of at-the-money and out-of-the-money strike prices.
The S&P 500 is an index composed of the top 500 stocks traded in the US, on either the New York Stock Exchange (NYSE) or the NASDAQ. Though other indexes could be used to calculate market volatility, the VIX utilizes the S&P 500 for its extensive scope. The Dow Jones Industrial Average (DJIA) may be more widely quoted in the US as a share price index, bur the S&P 500 is much more comprehensive: instead of the 30 stock prices represented in the DJIA, the S&P 500 incorporates 500!
2003’s change in calculating the VIX also allowed for the use of the prices of options with a larger range of strike prices—both calls and puts. This allows the VIX to utilize information from the “volatility skew” as well as at-the-money option series. (The “volatility skew” simply takes heed of the varying volatilities of specific options across different strikes.) This upgrade did not fundamentally change the VIX but brought improvement.
Today, the VIX can look at information from years before the development of its newest calculation methodology. Going back to 1990, the VIX has created records for its “new” index. For investors interested in studying volatility conditions during the last three decades or examine trends in the market related to performance and volatility of option prices, these figures are invaluable. Additionally, figures from the new VIX can be compared to those from the first index, providing useful information on the volatility skew.
The index of “fear”
Though it implies nothing about the market’s direction, the VIX is often referred to as the “fear index” or “fear gauge.” This is because the VIX, in a way, acts as a measure of the uncertainty of investors. Low numbers on the VIX means that investors expect stability in the market over the next 30 days. Higher numbers, though, demonstrate that volatility is likely to be high—and thus investors are probably going to be more uncertain.
That doesn’t mean, though, that a high VIX is necessarily indicative of a bearish market for stocks. Since the VIX measures market expectations of a move in either direction, bullish sentiment is just as likely to produce an expectation in investors of high volatility.
Regardless of whether the market is set to go up or down, option writers require significant premiums as compensation for the risk of large moves in the market. Buyers of options will pay those elevated premiums, though, if they believe big movements are likely to occur.
Correlation of the VIX with the S&P 500 Index
A clear negative correlation exists between the VIX and the S&P 500 Index. This relationship was dramatically exemplified when, in the second half of 2008, the VIX increased sharply as equity markets worldwide crashed.
This strong negative correlation exists because volatility, though non-directional, will increase when stock prices fall and investors experience high levels of stress and uncertainty. During these financial upsets, option prices rise as investors scramble to buy protection and speculators aim to profit from the market’s large movements.
How much fear saturates the minds of investors is reflected in the price option that sellers demand. When fears run high, so do option prices—after all, sellers need compensation for the risk they take on. Generally, option takers are prepared to pay this premium to protect their money.
The VIX: a leading indicator?
The VIX, to those who take a contrarian approach to the stock market, can also serve as a leading indicator of the share market’s direction.
According to this view, a high VIX means more panic in the market. Since market bottoms often occur during times of maximum panic and bearishness, an elevated VIX acts as a bullish signal. Low readings of the VIX, on the other hand, are thought to represent high levels of complacency. To a contrarian, optimism and complacency in the market is a signal of a peak. Thus, low levels of the VIX can be taken as a bearish signal.
Using derivatives over the VIX
After the changes the VIX underwent in 2003 to its method of calculation, it rapidly became a practical standard for trading and hedging volatility. Since then, CBOE has introduced various VIX futures and options—making a tradeable asset out of market volatility.
Since the VIX isolates volatility from other variables affecting the market, traders can use derivatives over the VIX to buy or sell in volatility without having to factor in things which influence trades in standard equity or index options: variables like interest rates, time to expiry, dividends, or the price of the underlying instrument can simply be ignored.
The ease that derivatives over the VIX give investors makes it a popular trade. Today, there are more than 100,000 trades each day in VIX options and futures.
One way to play: VIX futures
VIX futures contracts, introduced in 2004, are traded on the electronic CBOE Futures Exchange (CFE). The contract size of a VIX future is $1000 times the VIX index and the contract are cash settled to a Special Opening Quotation of the VIX.
Essentially, VIX futures are forward contracts on 30-day implied volatilities. A September contract, then, is a forward contract on 30-day implied volatility on the expiry date in September.
Unlike other futures and their underlying relationships, the relationship between the price of VIX futures and the VIX is not driven by cost of carry considerations. Stock index futures, for instance, have a constant pricing relationship between the underlying and the futures contract thanks to the possibility of arbitrage. However, VIX futures have no equivalent “carry” arbitrage, since the VIX is not a physical asset but only a prediction of volatility.
The specifics of how VIX futures are priced is a complicated matter, unnecessary for most investors to know. Without getting technical, the fair value of a VIX future is made by pricing the forward 30-day variance that underlies the settlement price of VIX futures. Prices of VIX futures can be more, less, or the same as the VIX: it all depends on the current view of 30-day volatility versus the predicted volatility of the period spanned by a futures contract
There are a couple of applications available for VIX futures:
Trading in the direction of implied volatility: traders often have an idea on how implied market volatility will move. Investors can trade that view using index options if they so choose, but VIX futures can give investors a more direct exposure that needs no adjustment when the market moves.
Making use of volatility spreads: investors can gain exposure to implied volatility changes by taking a spread between contracts with different expiry dates. If a trader goes short on VIX futures with a single month until their expiry and goes long on VIX futures with two months to expiry, they can reap the financial benefit if the difference between the two contracts widens—so long as the longer contract trades at a higher price than the one-month contract.
Another way: VIX options
In the early part of 2006, CBOE introduced options over the VIX. All VIX options share a multiplier of $100 and European exercise—meaning only on their expiry date can they be exercised. Their stunning success over the years since their inception has led them to become the most successful new product in the CBOE’s history.
As any options trader knows, there are an almost unlimited number of strategies available to employ. There’s no difference with VIX options. In fact, they are especially useful to traders in options in the S&P 500 Index, as they can be used to hedge volatility risk.
One last alternative: mini-VIX futures
CBOE’s newest offering—unveiled in 2009—are Mini-VIX futures. Designed to have smaller contract sizes than standard VIX futures, minis use a contract multiplier that is only $100 times the VIX. This tinier contract is meant to appeal to individual traders looking for exposure to volatility on a smaller scale.
Mini-VIX futures also match the contract size of VIX options, giving increased flexibility to investors looking to hedge their options positions or utilize a trading strategy with futures and options contracts of the same size.
Alternatives to the VIX: other volatility indices
As current markets remain uncertain, indices that measure volatility (and the expectation of volatility) in world markets are certain to retain their popularity. Instruments allowing investors to directly trade in volatility as an asset are sure to grow in demand, too—and that’s why VIX isn’t the only volatility index that CBOE calculates. The CBOE DJIA Volatility Index, Nasdaq-100 Volatility Index, and S&P 500 3-Month Volatility Index exist, as well. CBOE also uses VIX methodology to estimate expected volatility of popular commodities and foreign currencies.
Wrapping up on the VIX
When it comes to the US market, the VIX is the most widely used measure of share market volatility. Derived from the prices of options over the S&P 500 index, it represents the market’s expectations of short-term volatility and is negatively correlated with the S&P 500 Index. Thanks to the correlation between high levels of the VIX and bearish equity markets, the VIX is often called the “fear index.” Appropriately, it reached its all-time high during the global market crash of 2008.
Contrarian investors occasionally make use of the VIX as a leading indicator, taking extended high levels of the index as a bullish signal and long periods of low levels as a bearish indicator.
Multiple options exist for investors seeking to trade the VIX via derivatives listed on CBOE. Options, futures, and mini-futures enable investors to implement various strategies, whether diversifying their investment portfolios, taking directional views on volatility or hedging equity and/or equity derivatives positions.