October 12, 2017
What is the VIX?
We have had a few questions lately regarding the volatility index (VIX) and what it tracks and means in relation to the market. The Chicago Board Options Exchange (CBOE) created the VIX in 1993 to track the amount of expected volatility in the market and, of course, to make money. As many of our readers may know, the VIX is a market index that depicts the market’s expectation for 30-day volatility of the S&P 500 (SPX). Note that this is an expectation and not necessarily what will happen in the future. Unlike SPX, the VIX’s value is not derived from stock prices, instead the value is computed using options prices on SPX.
How is VIX calculated?
As we stated earlier, the CBOE uses hundreds of options prices on SPX to derive VIX’s value. The CBOE seeks to generate a weighted average of 30-day options prices. The prices and premiums on these options is constantly changing. Generally speaking, these premiums move opposite of the market. If we are in a bull market, investors will see premiums fall on these options. Likewise, if we are in a bear market, investors will most likely see options premiums increase. The increase in this premium is typically associated with increased risk on said option. This increase in risk accumulates to an increase in VIX. The opposite of this happens when options premiums fall; the VIX will decrease in value.
What does this value mean?
Mathematically speaking, the VIX is the expected annualized percentage change (+/-) of the S&P 500 in one year within one standard deviation (68%). We’ll use some arbitrary values for demonstration purposes. If VIX is currently at 20 and the S&P 500 is at $10,000, then investors can expect to see the S&P 500 between $8,000 and $12,000 in one year with 68% confidence. Note that an increase in VIX does not mean the market will neccesarilty fall. Because VIX returns +/- one standard deviation, the market can react in both a positive or negative way. VIX is often referred to as the “Fear Tracker” but this is only partially correct. Going back to our previous example. If we have a VIX of 50, a value far above the average (VIX average over time is around 18-20), then we could see S&P 500 fall to $5,000, but we could also see S&P 500 increase to $15,000. Of course, this is highly unlikely to see S&P 500 jump 50% in one year but for demonstration purposes we can see that an increasing VIX may not necessarily equate to a falling market.