The VIX is a highly touted index on CNBC and in financial circles, but what is it and what does it represent? You may hear it called the "Fear Index", but that too is a misnomer and not an accurate representation of what it is. Certainly there are times based on the price of this index that it construes fear, but other times it may reflect complacency.
What is it?
The VIX is a number derived from the prices of options premium in the S&P 500 index (which is an index comprising 500 large cap stocks).
It is a good indicator of the expectation of market volatility, note I said "expectation", it is not representative of the actual volatility or what will happen. This is a very important point; it is just a general assumption based on the premiums investors are willing to pay for the right to buy or sell stock.
This premium in options can be loosely defined as risk. Just like other forms of insurance, the greater the risk the higher the premiums, and the lower the risk the lower the premiums. When the options premium fall the VIX falls and when premiums rise the VIX rises. The VIX is not set by any one person, but rather the results of millions of transactions by millions of traders from around the world. The buyers and sellers move the option prices, more buyers and the premiums go up, more sellers and the premiums go down. The VIX takes a weighted average of all these options prices in the S&P 500 index and derives a single number that is called the VIX.
This one VIX number gives us a general idea if investors are paying more or less for the right to buy or sell the S&P 500 index.
