According to the Merriam-Webster dictionary, volatility is "a tendency to change quickly and unpredictably." As it pertains to the world of finance, volatility is best described as sudden and significant fluctuations in asset pricing. Periodic volatilities impact the trade of all securities, including forex, futures, debt and equities products.
To measure the activity in the American equities markets, the Chicago Board Options Exchange (CBOE) furnishes traders with its Volatility Index, known simply as the "VIX." The index attempts to project future stock market turbulence before it occurs. While not an infallible indicator, market participants from around the globe view the CBOE Volatility Index as a go-to barometer of forthcoming stock market volatility.
What Is The CBOE VIX?
The CBOE Volatility Index is a forward-looking derivatives product that addresses implied stock market volatility. By design, the VIX examines evolving price action in S&P 500 put and call options to quantify future stock market activity. Known as Wall Street's "fear gauge," the CBOE describes its feature product as follows:
"The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-tim, mid-quote prices of S&P 500 Index (SPX) call and put options."
For traders and investors, market volatility is a critical subject. Unexpected moves in asset pricing can lead to both extraordinary gains and losses ― it's imperative for anyone active in the markets to account for this phenomenon and its potential impacts. To do so, volatility is placed into two distinct contexts.
Historic volatility examines a security's price action relative to its past performance. It is quantified by examining pricing fluctuations with respect to established averages. Generally, as historic volatility increases, market conditions are becoming unhinged. As it decreases, market conditions are returning to a relative normal.
Implied volatility deals with projecting future market behaviour of a security. It is commonly forecasted by examining the participation and volatility of a security's put and call options prices. Calculations for implied volatility are complex as options pricing models are mathematically involved.
Functionally, the VIX is intended to be a real-time benchmark for expected volatility facing the U.S. stock market. However, even though the purpose is straightforward, the calculations behind the CBOE Volatility Index are intricate due to the structure of options pricing. Factors such as the bid/ask spread, strike price, risk-free rate and expiration must be included. The following are the required variables and general formula for calculating the VIX
|T||Time to expiration|
|F||Forward index level derived from index options prices|
|K0||First strike below the forward index level, F|
|Ki||Strike price of ith out-of-the-money option; a call if Ki>K0 and a put if Ki<K0; both put and call if Ki=K0|
|△Ki||(Interval between strike prices) - (half the difference between strike and Ki)|
|R||Risk-free interest rate to expiration|
|Q(Ki)||Midpoint of the bid-ask spread for each option with strike Ki|
O2 = ((2/T) Σi (△Ki / K2i) eRT) (Q(Ki)) - ((1/T)[F/K0 - 1]2 (1))
As you can see, the mathematics behind the VIX Index are extremely involved. Fortunately for active traders, values are calculated automatically at the exchange and expressed in the same fashion as a stock price. While different from forex currency pairs, the CBOE Volatility Index is listed in a numerical format, truncated at two decimal spaces for easy reference.
Trading The CBOE Volatility Index
The VIX is more than an indicator of volatility; it is also a tradable derivatives product. In fact, the VIX is frequently implemented as a viable tool for both risk management and speculation. To satisfy demand for a security that directly addresses market activity, the CBOE Volatility Index is available via two primary products.
VIX Futures (VX)
VIX futures were launched in 2004 and are regulated by the U.S. Commodity Futures Trading Commission (CFTC). The VX contract features a US$1,000 multiplier and is cash settled adhering to weekly and monthly expirations. As of January 2020, VIX futures traded with robust market depth, averaging more than 275,000 traded contracts per day.
VIX Options (VIX, VIXW)
Introduced in 2006, VIX options are Securities and Exchange Commission (SEC) regulated, with transactions being guaranteed by the Options Clearing Corporation (OCC). VIX options are traded under the symbols VIX for monthly contracts and VIXW for weekly expirations. Like the VIX futures contract, VIX options are cash-settled and trade in significant volumes. For January 2020, the average daily volume came in at 495,229, ensuring consistent market liquidity.
For traders with a moderate risk appetite, the CBOE offers the Mini VIX futures contract. The Mini VIX trades under the symbol VXM and is approximately 1/10th the size (US$100 multiplier) of traditional VIX futures. With reduced day trade and overnight margins, the Mini VIX contract furnishes traders with an opportunity to fully-customise their risk exposure.
Like other futures and options contracts, VIX products afford market participants the ability to take either long or short positions in the market. This is a key advantage, as it opens the door to capitalising on periods of extraordinarily high or low S&P 500 market volatility. In addition, the flexibility of VIX futures and options make them ideal tools for portfolio hedging, short-term speculation and longer-term investment strategies.
Interpreting The VIX
As with most indicators, the VIX may be interpreted in a multitude of ways. However, the fundamental tenet of the index is that it measures forthcoming or implied volatility facing the S&P 500. Accordingly, it is usually interpreted in one of two ways.
High VIX Readings
High VIX readings are associated with market tumult and uncertainty. Market participants view an abnormally high VIX as a sign of degrading market conditions or a precursor for a bullish reversal. Examples of extraordinary high values occurred during the panic of 2008 (96.40) and the coronavirus (COVID-19) outbreak of 2020 (85.47).
Low VIX Readings
Low VIX readings are associated with calm markets and security. Traders and investors typically view low VIX figures as an indication of a solid economic cycle. However, when a low VIX persists, many view a bearish stock market reversal due to complacency as likely. To illustrate, the low VIX readings of December 2006 (8.60) and January 2020 (11.75) preempted the severe stock market corrections of 2007 and spring 2020.
It's important to remember that the concepts of "high" or "low" are relative to historic and recent levels. For instance, the onset of the COVID-19 pandemic in spring of 2020 spiked the VIX dramatically. During March 2020, the VIX rose to a high of 85.47, nearly eight times January 2020's low of 11.75. Conversely, January 2020's low (11.75) was only a fraction of the VIX's long-term median value.
Note: Past performance is not indicative of future results.
Due to the fact that the VIX is a dynamic stock market derivative and indicator, many traders use moving averages to place current values into context. One such tool is the 10-day simple moving average (SMA). As VIX valuations move higher above the 10-day SMA, the chance of an S&P 500 rally would be perceived to grow. If the VIX falls below the 10-day SMA, stock valuations would be expected to fall from current levels. In either case, appropriate trading strategies may be adopted to capitalise on the perceived signal.
The CBOE Volatility Index is a popular forecasting and trading tool for U.S. stock market participants. Based on S&P 500 options activity, the VIX is a measure of the implied volatility facing the broader American equities markets. Known as Wall Street's "fear gauge," it is frequently referenced by traders, investors and the financial media as a way to quantify future stock market turbulence.