The VIX Index And How It’s Used

The VIX Index is a tool used by investors to try to predict how the broader equity market will move in the near future.  VIX is the ticker symbol of the CBOE (Chicago Board Options Exchange) Volatility Index.  It shows investors the expected volatility of the market over the next 30 days.  It is often referred to as the ‘investor fear gauge’ or ‘investor fear index.’

The VIX Index is created by considering the volatilities of out-of-the-money S&P index options.  It’s calculated from both calls and puts.  Although it shows the expected market fluctuations in the next 30 days, it also annualized.

The VIX index used to be the VXO index and it was calculated using the S&P 100 index for at-the-money options.  From 2003 on, it has used the S&P 500 in order to draw its data from a wider range of stock options.  While the VIX tracks the S&P 500, there are two other volatility indexes that are used.  The VXN uses the Nasdaq 100 and the VXD uses the Dow Jones Industrial Average.

How Is VIX Calculated?

The VIX index is calculated using the Black-Scholes option pricing model.  This model is used to determine the implied volatilities of a large number of stock options, which are then combined to present an overall picture of what the market will do in the near future.  The figure is represented as a percentage.  For example, a VIX Index of 12 means that the market expects a change in price of 12% in the next year.

The Daily VIX Index

Daily calculations of implied volatility are also made and expressed as a daily VIX Index.  This expresses how much the market will change between closing and reopening.  This is useful for investors who have call and put options and are considering what to do with them.

Typically, traders take the annualized volatility figure and divide it by the square root of trading days in a year to determine the daily volatility change rate. For example, let’s say there are 256 trading days in a year, the square root of this is 16. If the annualized VIX volatility is 12% then the daily volatility is 0.75%. This means that the S&P is expected to move 0.75% during the next trading day, with 66.6% accuracy.

What The VIX Means

Why is it called the ‘investor fear gauge?’  The reason is that it rises sharply whenever markets are under stress or there is financial turmoil.  This is not because of panic on the part of investors, but simply because during these times of stress, the market’s implied volatility rises.  However, this panic by investors tells us that there is increased volatility, and this is useful in making market decisions.

Using The VIX Index To Your Advantage

How can the VIX Index help you make informed investment decisions?  When the market’s volatility is rising, this is a sign that we’re on the brink of a new market trend or a major turning point.  This means that when it rises, this is the time to act. And when volatility is up, usually it signals weakness in equity markets.

Volatility also has a direct impact on the prices of put and call option premiums.  It causes both to rise.  Knowing that a high VIX Index means high premiums can help you make decisions whether you’re holding the options or considering buying.

You can actually trade VIX derivatives as well.  This is a new option and few investors take full advantage of it.  Although you can’t trade on the CBOE directly, there is a variety of different VIX options, futures and ETNs available for investment.  These can add some volatility exposure to your portfolio.

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