Market Volatility Index (VIX)

The Market Volatility Index (VIX) is a measure of implied volatility in trading of S&P 500 futures on The Chicago Board Options Exchange. The index is calculated using a formula that considers a large number of option strike prices, supposedly in a way based on current financial research and practice. Values for VIX tend to be between 5 and 100.

So what is ‘implied volatility’? To understand this, first consider the factors that go into the pricing of options. One of them is ‘volatility’. It’s simply the extent to which the price of something has changed over a year, measured as a percentage. An option on a more volatile stock or future will be more expensive. But options are just like any other asset, and are priced based on the law of supply and demand. If there is an excess of supply compared to demand, the price will drop. Conversely, if there is an excess of demand, the price rises. Since all the other parameters of the option price are predictable or measurable, the piece that relates to demand can be isolated. It’s called the ‘implied volatility’. Any excess or deficit of demand would suggest that people have a difference in expectation of the future price of the underlying asset. In other words, the future or ‘expected volatility’ will tend to be different from the ‘historic volatility’.

The CBOE has a rather complex formula for averaging various options for the S&P 500 futures to get a hypothetical, normalized, ‘ideal’ option. The volatility component can be isolated from the the price of this ideal option. That’s VIX. Although both ‘put’ and ‘call’ options are included in the calculation, it is the ‘put’ options that lead to most of the excess demand that VIX measures.

The VIX is said to to measure market sentiment (or, more interestingly, to indicate the level of anxiety or complacency of the market). It does this by measuring how much people are willing to pay to buy options, typically ‘put’ options which are a bet that the market will decline. When everything is wonderful in the world, nobody wants to buy put insurance, so VIX has a low value. But when it looks like the sky is falling, everybody wants insurance in spades and VIX heads for the moon. Practically, even in the most idyllic of times, VIX may not get below 12 or 13. And even in the worst of panics, in 1998, VIX did not break much above 60.

Many view the VIX as a contrarian indicator. High VIX values such as 40 (reached when the stock market is way down) can represent irrational fear and can indicate that the market may be getting ready to turn back up. Low VIX values such as 14 (reached when the market is way up) can represent complacency or ‘irrational exuberance’ and can indicate the the market is at risk of topping out and due for a fair amount of profit taking. There’s no guarantee on any of this and VIX is not necessarily by itself a leading indicator of market action, but is certainly an interesting indicator to help you get a sense of where the market is.

The CBOE changed calculation of the VIX to use the S&500 index in 2003 (the “new VIX”). Until 2003, this indicator was calculated using the S&P 100 future, also known as the OEX, based on the prices of 8 calls and puts on the OEX that expire in approximately 30 days. The old VIX indicator value is still available as ticker VXO.

Here are some additional resources for the VIX:

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Contributed-By: Jack Krupansky, Chris Lott