Volatility Index Meaning
Volatility Index, abbreviated as VIX, gives an indication of the expected volatility in the stock market and is based on S&P 500 index options based on 30 days forward period. This index was created by Chicago’s Board Options Exchange and is also known as CBOE Volatility Index.
History
The history of VIX can be traced back to the year 1993 when the Chicago Board Options Exchange (CBOE) had announced the launch of the index. At that time, the index was measured as a weighted average of the implied volatility of the total eight options of 30 days S&P 100 index. Later in the year 2003, CBOE worked in collision with Goldman Sachs and replaced the index from S&P 100 index to S&P 500 index. Since then, the same method continues to be used to date. Further, futures and options were introduced for VIX trading in the years 2004 and 2006, respectively.
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Source: Volatility Index (wallstreetmojo.com)
How does the Volatility Index Work?
The term volatility in the case of the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more refers to a statistical measurement of the degree of change in the prices of the stock market products over a period of time. The VIX calculated the expected volatility based on the call and put option prices of S&P 500 stocks. The weighted averageWeighted AverageThe weighted average formula is simply summing up the products of each value with its respective weightage. Here, more significance is given to the weightage of the values rather than the variables themselves.read more prices of the S&P 500 put, and call options are added together for a number of strike prices. The midpoints of the bid and ask pricesAsk PricesThe ask price is the lowest price of the stock at which the prospective seller of the stock is willing to sell the security he holds. In most of the exchanges, the lowest selling prices are quoted for the purpose of the trading. Along with the price, ask quote might stipulate the amount of security which is available for selling at the given stated price.read more of options are taken into account for index calculations.
There are two kinds of S&P options that are considered for VIX i.e., those that expire on the third Friday of every month and those that expire every Friday. The weighted average of the prices of the options is then calculated in order to arrive at the index value as per CBOE.
Volatility Index Chart
Below is a historical graph that shows the Index values for various years. The years are represented on the x-axis, and the respective VIX values are represented on the y-axis.
The index value, as on 17th July 2020, is at 25.68. As mentioned earlier, the index indicates market volatility over a period of the next 30 days.
Interpretation
The index is expressed as a percentage and represents the expected annualized movement of the S&P 500 during the period of the upcoming 30 days. For example, when the index stands at 36, it indicates that the expected movement in the S&P 500 in the next 30 days is 3% (i.e., 36% divided by 12 months).
When the market is showing trend upwards, there appears less volatility as confidence amongst the investors increases, and they tend to buy more calls rather than put. On the other hand, when the market is on a falling end, it creates panic amongst the market players as more put options are bought instead of call options, leading to more volatility in the market. Thus, in a bullish market, VIX is generally lower due to less volatility, and in the bearish marketBearish MarketBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more, VIX is higher due to unrest in the market. Thus, there exists an inverse relationship between market performance and the index.
Criticism
Sometimes analysts criticize the usage of VIX for predicting future volatility in the market. It is being criticized on the following arguments.
- The intensity with which VIX forecasts volatility is equivalent to that of simple methods such as simple past volatility.
- The only thing that VIX tracks are price inverse, and there is the absence of predictive power in VIX.
- VIX represents only implied volatilityImplied VolatilityImplied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model.read more as it is unable to predict volatility in case of abnormal conditions in the future.
- VIX was also alleged for being manipulated by an unknown whistleblower.
Uses
The Volatility Index (VIX) can be used by the investors for deciding their timing of the trades in the market. The users can analyze the trend in the volatility index and make the best use of it to its advantage as follows –
- The index is used to find out the expected ups and downs in the market. When the VIX starts to show a significant increase, it means that there is going to be some major change in the market, and it is the best time to act upon. When the index is high, it indicates a downfall in the stock market.
- The volatility index also impacts the prices of put optionsPut OptionsPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more and call options, and both of them increase. When the index is high, the higher premiums should be considered to decide whether to hold the options or to buy them.
- Trading can also be done in VIX futures and options. A lot of investment opportunities are available for the same.
Conclusion
VIX is being used for determining the movements in the stocks of the S&P 500. There exists an inverse relationship between the market and the index. When this relationship doesn’t follow for a particular period of time, the present direction of stocks is said to be unsustainable for a short period of time.
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