An introduction to CBOE Volatility Index VIX

QuietGrowth - An introduction to CBOE Volatility Index VIX

The CBOE (Chicago Board Options Exchange) Volatility Index, also known as VIX, is a popular index that measures the expected volatility of the US stock market. It is a valuable tool for investors and traders to understand market sentiment, assess risk, and develop investment strategies.

VIX, also referred to as the “Fear Index,” measures the expected 30-day volatility of the S&P 500 index. The S&P 500 is a broad market index representing the largest 500 companies listed on the New York Stock Exchange or Nasdaq. VIX measures the market’s expectation of volatility over the next 30 days based on the prices of options on the S&P 500 index.

Professor Robert Whaley of Duke University developed the concept of VIX in the early 1990s. The CBOE introduced VIX in 1993 as a way for investors to measure the implied volatility of the S&P 500 index options. Since then, VIX has become a widely followed barometer of market sentiment.

Calculation of VIX

The calculation of VIX is based on the prices of options on the S&P 500 index. Options are contracts that give the buyer the right but not the obligation to buy or sell an underlying asset, such as the S&P 500 index, at a specified price (the strike price) on or before a specified date (the expiration date). Option prices reflect the market’s expectation of the underlying asset’s future price movements.

CBOE calculates the VIX using a complex formula that considers the prices of a range of S&P 500 index options with different strike prices and expiration dates. The formula uses a weighted average of the implied volatilities of these options to arrive at a single number representing the market’s expectation of volatility over the next 30 days.

The formula for VIX is proprietary and not disclosed by the CBOE. However, the CBOE provides real-time data on VIX, so investors and traders can monitor its movements.

Interpretation of VIX by the market participants

VIX is used as a measure of market sentiment and risk. When VIX is high, it indicates that investors expect more volatility in the market. This may be due to multiple factors such as geopolitical events, economic data releases, or company earnings announcements. High VIX values can be a sign of market uncertainty and can lead to increased risk aversion among investors.

On the other hand, when VIX is low, it suggests that investors expect less volatility and a relatively stable market. Low VIX values can indicate a sense of complacency among investors and may lead to increased risk-taking behaviour.

VIX can also be used as a tool for hedging and managing risk in investment portfolios. For example, investors can buy VIX futures or options to hedge against potential market downturns. This can help protect their portfolios from losses during times of market volatility.

Moreover, volatility traders, specialising in trading volatility products such as options and futures contracts on the VIX, use the VIX to make trading decisions and to hedge their positions.

The VIX is a dynamic index that can change quickly in response to new events and market conditions. Therefore, many investors and traders monitor the VIX in real-time to understand the factors that drive its movements.

Example of VIX values

Let’s say the current level of the VIX is 20, which means the market expects the S&P 500 index to have an annualised volatility of 20% over the next 30 days.

If the VIX rises to 30, the market is now expecting the S&P 500 index to have an annualised volatility of 30% over the next 30 days. This may be due to multiple factors, such as an unexpected event, a change in economic data, or a shift in investor sentiment.

In this scenario, a trader who believes the market will become more volatile may consider buying options on the VIX or shorting the S&P 500 index to hedge against potential losses. On the other hand, an investor who is confident in the market’s stability may decide to hold onto their positions and ride out any short-term volatility.

Over the years, the VIX has seen a wide range of values, reflecting the different market conditions and events. For example, during the global financial crisis of 2008-2009, the VIX reached its all-time high of 89.53 on October 24, 2008, as investors were concerned about the stability of the financial system and its impact on the global economy.

In contrast, during periods of relative stability, the VIX has been at lower levels. For example, in 2017, the VIX had an average value of 11.1, reflecting a period of low volatility and a relatively stable market environment.

Alternatives to VIX

While the VIX is the most widely used measure of implied volatility in the market, there are several alternative volatility measures that traders and investors can use. Here are some of the alternatives to VIX:

  • VXN: The VXN measures implied volatility on the NASDAQ 100 index. Like the VIX, it is calculated using the prices of options contracts on the index.
  • RVX: The RVX measures implied volatility on the Russell 2000 index, a widely used benchmark for small-cap stocks.
  • EVZ: The EVZ measures implied volatility on the Euro Stoxx 50 index, a benchmark for European equities.
  • VXEEM: The VXEEM measures implied volatility on the MSCI Emerging Markets Index, a widely used benchmark for emerging market equities.
  • HV20: The HV20 measures historical volatility, which is calculated based on the actual price movements of an underlying asset over the past 20 days.

Each alternative volatility measure has its own strengths and weaknesses, and traders and investors may choose to use different measures depending on their individual investment strategies and objectives. Ultimately, the choice of volatility measure will depend on the specific needs of the trader or investor and the market conditions they seek to navigate.

Drawbacks of VIX

While the VIX is a widely used and respected measure of market volatility, it is prudent to recognise some potential drawbacks and limitations to the index. The main drawbacks of the VIX include:

  • Limited scope: The VIX only measures volatility on the S&P 500 index, representing only a portion of the overall equity market. This means that the VIX may not accurately reflect volatility in other sectors or asset classes.
  • Short-term focus: The VIX is primarily focused on short-term volatility, with a horizon of 30 days. This may not be sufficient for longer-term investors more interested in long-term trends and fluctuations.
  • Implied volatility may not be accurate: The VIX is calculated using the implied volatility of options contracts on the S&P 500 index, which may not always accurately reflect actual market volatility. In some cases, implied volatility may be higher or lower than actual volatility, leading to inaccurate readings from the VIX.
  • Susceptible to manipulation: Like any market index, the VIX is susceptible to manipulation by traders and market participants who seek to profit from its movements. This can lead to distortions in the index and make it less reliable as a measure of market volatility.

So investors and traders need to be aware of the limitations of VIX and to use VIX in conjunction with other measures and analyses.

Why is the formula of VIX proprietary?

The formula for calculating the VIX is proprietary because it is a valuable and closely guarded intellectual property of the CBOE, which owns the rights to the VIX index.

The CBOE invests significant resources in developing and maintaining the VIX formula, which involves collecting and analysing large amounts of options market data. The formula is constantly refined and updated to ensure that the VIX accurately reflects the changes in market volatility and risk.

By keeping the VIX formula proprietary, the CBOE is able to maintain a competitive advantage in the market for volatility products and services. The formula is a vital component of the CBOE’s business, and making it publicly available would diminish the CBOE’s competitive position and potentially undermine the value of the VIX as a benchmark for market volatility.

Despite the proprietary nature of the VIX formula, the CBOE provides extensive documentation and information about the index, including its methodology, historical values, and real-time data. This information allows traders and investors to use the VIX as a tool for managing risk and making informed investment decisions while preserving the value of the index as a proprietary product of the CBOE.

Related information

Refer to the related knowledge resources:

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