VIX: Understanding the volatility index and its impact

Skilling Writers Team
2023-03-24
- Trading
- Indices

If you're familiar with the stock market, you've likely heard of the VIX, also known as the Fear Index. This elusive indicator measures the level of fear and uncertainty in the market, and its impact can be felt in every corner of the financial world. In this guide, we'll take a deep dive into the world of the VIX, explaining what it is, why it matters, and how it can affect your investment decisions.

What is VIX?

Also known as the Volatility Index or the Fear Index, it is a market indicator that measures the level of fear and uncertainty in the market based on S&P 500 options trading. It was created by the Chicago Board Options Exchange (CBOE) in 1993 and has since become a widely recognized gauge of market sentiment. It is calculated using options prices, and its value is derived from the expected volatility of the S&P 500 index over the next 30 days. The relationship between the S&P 500 and VIX is interesting: when the S&P 500 goes up, the VIX tends to go down, and vice versa. This strong negative correlation and the VIX's unique characteristics make it a crucial factor to consider when making investment decisions.

How to calculate the VIX?

It is calculated using the prices of S&P 500 options. Specifically, it is based on the prices of options that are near the money and have 30 days until expiration. The formula for calculating the VIX involves finding the implied volatility of these options, which is the expected volatility of the S&P 500 over the next 30 days based on the prices of the options. This calculation is repeated for a range of options, and then the weighted average of these implied volatilities is used to derive the VIX value. The calculation is complex, and it requires specialized software and expertise in options pricing and volatility modeling.

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How to use VIX in trading

As a hedge: One common use of the VIX is as a hedge against market volatility. If you hold long positions in the market, you can purchase VIX options or futures to protect against a sudden drop in the market.
As a contrarian indicator: The VIX tends to rise during periods of market stress and panic, which often signals a market bottom. Conversely, when it is low, it can be a sign of complacency and a potential market top. Therefore, some traders use it as a contrarian indicator to guide their trading decisions.
As a market timing tool: Some traders use the VIX to time their market entries and exits. For example, if the VIX is high, it may be a good time to buy stocks at a discounted price. Conversely, if it is low, it may be a good time to sell stocks and take profits.
As a volatility trading tool: Finally, some traders use the VIX as a tool for trading volatility directly. This can be done through options or futures on the VIX itself, or through other volatility-related instruments. This is a more advanced trading strategy and requires a thorough understanding of options and volatility trading.

Overall, the VIX can be a useful tool for traders, but it should be used in conjunction with other technical and fundamental indicators to make informed trading decisions.

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Why trade the VIX?

Hedging against market volatility

Let's say you have a portfolio of stocks that you believe will perform well in the long term, but you're concerned about short-term market volatility. By purchasing VIX options or futures contracts, you can protect your portfolio from downside risk.

Speculative trading opportunities

During times of high volatility, it can spike, providing opportunities for traders to profit from short-term price movements.

For example, during the COVID-19 pandemic in early 2020, it hit a record high of 82.69 on March 16th, as global markets tumbled due to uncertainty about the impact of the virus.

Traders who bought VIX ETFs or options before the spike could have made significant profits in a short period of time.

Market timing

It can also be used to time market entries and exits. For example, if the VIX is high, it may be a good time to buy stocks at a discounted price. Conversely, if it is low, it may be a good time to sell stocks and take profits.

Interpretation of the VIX index

A high VIX reading generally indicates that investors are expecting a high level of volatility in the market over the next 30 days, while a low VIX reading suggests that investors are expecting relatively stable market conditions.

Here are some possible interpretations of different VIX levels:

0-15: Extremely low volatility	15-20: Low volatility	20-30: Moderate volatility	30-40: High volatility	Above 40: Extreme volatility
This is generally a period of calm in the markets, with little expected movement up or down.	This suggests that the market is relatively stable, with only small fluctuations expected over the next 30 days.	This level indicates that investors are expecting some market movement over the next month, but not a significant amount.	This suggests that investors are concerned about market uncertainty and potential downside risk, and are expecting significant price swings over the next 30 days.	This level indicates that investors are very worried about market uncertainty, and are expecting significant price swings and potentially sharp market declines.

The limitations of the VIX index

It has some limitations when it comes to accurately predicting stock market volatility. One limitation is that it is based on the implied volatility of S&P 500 options, which may not always reflect actual market volatility.

For example, during the COVID-19 pandemic in early 2020, it spiked to record levels as investors expected high volatility in the stock market. However, the actual volatility in the market exceeded even the elevated expectations reflected in the index.

Another limitation is that it can be influenced by external factors beyond the stock market.

For example, Federal Reserve policies and geopolitical events can impact it, even if they do not directly impact the underlying stock market.

For instance, if the Federal Reserve announces a change in its monetary policy, it can lead to a spike in the index as investors anticipate how this change may impact the stock market. Similarly, if there is a sudden geopolitical event, such as a terrorist attack or a major political crisis, it can cause it to spike

Therefore, while the index can be a useful tool for measuring market volatility, it is important to be aware of its limitations and use it in conjunction with other indicators when making investment decisions.

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Instruments most affected by the VIX

Options: The VIX is calculated based on the prices of S&P 500 index options, so it is not surprising that options are the most directly impacted by changes in the VIX. As the VIX increases, the implied volatility of options also increases, making options more expensive.
Futures: The VIX futures market allows investors to trade on future expectations of market volatility. The prices of VIX futures contracts are closely tied to the VIX index, so changes in the VIX can have a significant impact on VIX futures prices.
Exchange-traded funds (ETFs): Several ETFs track the VIX (or VIX futures) contracts, such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the ProShares VIX Short-Term Futures ETF (VIXY). These ETFs can experience significant price swings in response to changes in the VIX.
Stocks: The stock market can be impacted by changes in the VIX, as higher volatility can lead to greater uncertainty and risk aversion among investors. This can cause stock prices to decline, particularly for companies with more volatile earnings.
Credit markets: The VIX can also impact credit markets, such as corporate bonds and credit default swaps. Higher volatility can lead to increased risk aversion among lenders, which can make it more difficult for companies to obtain financing.

Summary

While the VIX has its limitations, it can provide valuable insights into investor sentiment and expectations for future market movements. Understanding it and its impact on financial instruments can help investors make more informed decisions and better manage their investment portfolios.

As with any investment tool, it's important to do your research, consult with professionals, and consider your risk tolerance before making any investment decisions.

If you're interested in learning more about the VIX and how it can be used to manage risk in your portfolio, consider speaking with a financial advisor or doing additional research on the topic. With the right knowledge and tools at your disposal, you can make more informed investment decisions and achieve greater success over the long term.

Not investment advice. Past performance does not guarantee or predict future performance.