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What Is the VIX? Why Is It Important?

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What Is the VIX? Why Is It Important?

VIX seeks to predict market volatility through options trading.


What is the VIX and how does it measure volatility?

In the financial world, VIX is short for the Chicago Exchange Volatility Index. The index measures S&P 500 options and is used as an overall benchmark for stock market volatility. The higher the index level, the more volatile the trading environment, which makes its other nickname very apt: the fear index.

It is important to point out that the VIX measures implied or theoretical volatility. It measures expectations for future volatility based on a snapshot of trading activity over the past 30 days.

What do the VIX numbers mean?

A VIX level above 20 is generally considered “high”. A VIX below 12 is generally considered “low”. Anything between 12 and 20 is considered “normal”.

When put option activity increases, which means investors are selling more puts, the VIX records high numbers. Investing in put options is like betting that the stock price will fall before the put contract expires, because put options give investors the right to sell the stock at a specific price on a specific date.

These are bearish investments that can capitalize on emotions such as fear. There is a saying on Wall Street that “when the VIX is high, it’s time to buy” because of the general belief that volatility may have peaked or turned.

When the VIX falls, it means investors are buying more call options. Investing in call options is like betting that the stock price will rise before the call option contract expires. In other words, a decline in the VIX indicates a more bullish or bullish overall sentiment in the stock market. Although the VIX index is not expressed as a percentage, it should be understood as a percentage. A VIX of 22 means the SPX’s implied volatility is 22%. This means that the index has a 66.7% chance (statistically one standard deviation) of trading within a 22% range above or below current levels over the next 12 months.

How is VIX calculated? What is the VIX formula?

Simply put, the VIX is calculated by the CBOE using market prices for S&P 500 put and call options with an average maturity of 30 days. It uses standard weekly SPX options and options that expire on Friday, but unlike the S&P 500, which includes specific stocks, the VIX consists of an ever-changing portfolio of SPX options. Its methodology and selection criteria are described in more detail on the CBOE website.

How to interpret the VIX?

There are many ways to interpret the VIX, but it’s important to note that it’s a theoretical measure, not a crystal ball. Even the sentiment it tracks, fear, is not itself measured by hard data like the latest consumer price index. Instead, the VIX uses option prices to estimate how the market will perform on future time frames.

The VIX does not measure actual volatility, it measures implied volatility.

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street dictionary term

It’s also important to understand how much emotion can drive the stock market. For example, during earnings season, a company’s stock may report solid growth but plummet because the company missed analysts’ expectations. A lot of what happens in the market can be summed up in feelings like greed, as investors spot upside potential and place buy orders, which drive the overall price higher. Fear is demonstrated when investors try to protect their investments by selling stocks, pushing prices lower.

At worst, fear-driven selling can throw markets into chaos and lead to emotions such as panic that can lead to capitulation.

But the VIX wasn’t designed to cause panic. It’s just a measure of volatility. In fact, some investors, especially traders, see heightened volatility as a buy signal, taking advantage of the momentum by speculating or hedging to profit.

Can the VIX exceed 100?

In theory, the VIX could be in the top 100, although it hasn’t reached that point since it began collecting data in 1990.

The two highest points the VIX has ever reached are as follows:

On October 24, 2008, at the height of the financial crisis triggered by the implosion of global mortgage-backed securities, the VIX reached 89.53. On March 16, 2020, in the early days of the COVID-19 pandemic, the VIX recorded a peak of 82.69.

Analysts also believe that if data collection began in the 1980s, the VIX would have exceeded 100 during the black market crash on Monday, October 19, 1987.

This chart from Federal Reserve data center FRED details the VIX from 1990-2022. Shaded areas indicate recessionary periods:

Fred Volatility

How to trade VIX? Can you buy options on the VIX?

Investors cannot invest in the VIX directly, but can invest in derivatives that track the VIX, such as VIX-based exchange-traded funds (ETFs), such as the ProShares VIX Mid-Term Futures ETF (VIXM), and exchange-traded notes, such as the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) and iPath Series B S&P 500 VIX Medium-Term Futures ETN (VXZ).

What is the VIX today?

To view current readings of the VIX, visit the webpage maintained by the CBOE; it is updated daily.

What is the current volatility forecast for the VIX?

The stock market has been choppy for most of 2022. Tech stocks, Nasdaq and stocks with high price-to-earnings ratios take a hit as investors worry about persistent inflation, the impact of the Russia/Ukraine war on energy prices, the aggressive pace of Fed rate hikes, and China’s extreme “coronavirus” policy . All of this is causing storm clouds to gather around the possibility of a recession.

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