What Is The VIX?
The CBOE Volatility Index (VIX) is a market gauge that measures market uncertainty by calculating the price that traders are willing to pay for S&P 500 options.
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How The Cboe Volatility Index is Used by Investors
The Cboe Volatility Index (VIX) is a handy barometer that measures the level of risk or uncertainty in the American equity market. It tracks expected price changes on the S&P 500, which many investors consider to be the most important of the major American stock indexes.
Pundits love to point to VIX when the market is plunging, as VIX tends to spike dramatically during market corrections. People will often talk about how the risk index is soaring during these sorts of sudden market declines. Conversely, when the VIX is unusually low, many market commentators use it to indicate that the market is too relaxed and potentially set up for a significant rise in volatility.
How Is the VIX Volatility Index Calculated?
The VIX Volatility Index is calculated by adding up and averaging the options prices of a great number of calls and puts on the S&P 500 index. The formula for VIX incorporates all weekly and monthly S&P 500 options that are set to expire within 23 and 37 days of the current trading day.
By averaging all these prices together, it gives traders a quick way to check the overall expectation of volatility on the market's key S&P 500 index over the next month. And, since these are all standardized options on a major exchange, it's easy for traders to know that the prices are valid and statistically meaningful, making VIX a trustworthy gauge.
Note: The VIX Index is a mathematical construct built from averaging the prices of numerous short-term S&P 500 options. This means it acts quite differently from something like gold or oil indexes, which track the price of an ounce of gold or barrel of crude more directly.
What Does a High VIX Mean?
A high VIX means that traders expect the underlying futures index, in this case the S&P 500, to see choppy trading going forward. When the VIX is rising, this means that traders are paying more for the average monthly S&P 500 put or call option. Traders pay more because they expect bigger price swings.
In general, a high VIX is associated with a falling stock market. Generally, the highest VIX readings are seen during major market panics such as the 2008 Financial Crisis and the Covid-19 shock of March 2020. Sometimes, VIX also spikes ahead of upcoming events that could lead to market turmoil, such as presidential elections.
What Does a Low VIX Mean?
A low VIX means that traders aren't willing to pay too much for put and call options on the S&P 500. This usually happens during periods of quiet market trading where the S&P 500 forms small average trading ranges each day. During this sort of period, traders aren't willing to pay much for protection against market swings, and thus prices of S&P 500 calls and puts are muted.
Historically, the VIX tends to settle in the 15-20 range during an average market. A VIX reading below 15 tends to indicate a state of complacency about the S&P 500. Whereas, when the VIX ticks well above 20, it indicates a level of heightened concern around the market going forward.
VIX vs. Other Indices
It's vital to understand that the VIX index is not designed to track any long-term financial assets. Most indexes or futures contracts are tied to tangible assets such as common stocks, currencies, bonds, gold, and so forth. VIX, however, tracks options on the market which, in turn, expire within a month or so. As such, the index doesn't trend upward or downward over time, rather it tends to be mean-reverting, with the price heading back to around a median reading of 18 whenever market conditions stabilize.
Thus, VIX works totally differently from something like the S&P 500. That index owns 500 of America's largest companies, and thus generally tends to appreciate over time as the value of those businesses grows. The VIX, by contrast, does not trend higher or lower over time.
The VIX is quite unique, in that there aren't many indexes which are designed to be mean-reverting rather than following the value of an underlying commodity or group of stocks. That said, there are now volatility indexes for other products such as the NASDAQ, crude oil, and foreign currencies. However, the VIX for the S&P 500 remains the most widely-quoted and understood barometer of general market volatility.
How To Buy & Trade the VIX
It's important to remember that the VIX itself is a mathematical calculation derived from a variety of relatively illiquid S&P 500 options prices. As such, it would be nearly impossible to create a product to buy or sell VIX directly.
When traders talk about buying or selling the VIX, they're usually referring to trading funds such as:
- iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX)
- ProShares Short VIX Short-Term Futures ETF (SVXY)
These track the prices of futures contracts on the VIX which are set to expire at a set date in the future, rather than the spot price of VIX. As such, these funds will often show returns far different from the movement in the underlying VIX index itself.
In general, funds that are long volatility, such as VXX, will rise when volatility increases and the equity market declines. Similarly, funds that bet on lower volatility, such as SVXY, tend to rise when volatility declines and equity markets are stable. However, there can be significant deviations from spot VIX prices, and traders should also monitor potential contango and backwardation closely before making trades on these sorts of ETFs and ETNs.
How Investors Can Use VIX
- Buy market protection when VIX is low: When the VIX is low, it can be a good time to buy market protection. That could be in the form of a VIX ETF or through the purchase of put options on the S&P 500 or other equity indexes.
- As a market timing signal: VIX is a mean-reverting index that doesn't trend over time. This means that certain numbers always tend to hold importance. Some traders like to buy stocks when the VIX hits historically high numbers such as 30 or 40. Likewise, when the VIX hits unusually low levels such as 10 or 12, it might be a good time to take profits on the stock market.
- To trade volatility bullishly: When the VIX is low, some traders like to buy VXX or other such volatility products as a speculation on rising volatility. These sorts of trades are often risky due to contango, but can be highly profitable if the market quickly corrects.
- To trade volatility bearishly: Many traders like to bet against volatility when the VIX index rises to high levels by shorting products such as VXX.
Note: It's not possible to buy or sell VIX directly. Use caution when trading VIX-related ETFs as they often react much differently than the quotation of VIX itself when the level of volatility changes.
Bottom Line
The VIX Index is a widely-quoted barometer of uncertainty in the stock market. However, it's not as simple as just buying VIX when the index is low and vice versa. Knowing the ins and outs of how VIX works should help traders make better decisions the next time volatility makes one of its infamous surges.
This article was written by
Ian Bezek is a former hedge fund analyst at Kerrisdale Capital. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.
Ian leads the investing group Learn more .Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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