Understanding the CBOE Volatility Index (VIX) in Investing

What Is the CBOE Volatility Index (VIX)?

The CBOE Volatility Index (VIX) is a real-time market index extensively used by investors to evaluate market sentiment and perceived risk. By representing the expected volatility of the S&P 500 over the next 30 days, the VIX acts as a barometer of investor fear and uncertainty, making it a crucial indicator in assessing market dynamics.

The index is more commonly known by its ticker symbol and is often referred to simply as “the VIX.” It was created by the CBOE Options Exchange and is maintained by CBOE Global Markets. It is an important index in the world of trading and investment because it provides a quantifiable measure of market risk and investors’ sentiments.

Understanding How the VIX Index Functions

The VIX attempts to measure the magnitude of the S&P 500's price movements (i.e., its volatility). The more dramatic the price swings in the index, the higher the level of volatility, and vice versa.

Traders can use VIX futures, options, and ETFs to hedge or bet on changes in the index's volatility.
In general, volatility can be measured using two different methods. The first method is based on historical volatility, using statistical calculations on previous prices over a specific time period. This process involves computing various statistical numbers, like mean (average), variance, and the standard deviation on the historical price data sets.

The second method, which the VIX uses, involves inferring its value as implied by options prices. Options are derivative instruments whose price depends upon the probability of a particular stock’s current price moving enough to reach a particular level (called the strike price or exercise price).

Since the volatility factor represents the possibility of such price moves occurring within the given time frame, various option pricing methods (like the Black-Scholes model) include volatility as an integral input parameter.

Because option prices are public, they can be used to determine the volatility of an underlying security. Such volatility, as implied by or inferred from market prices, is called forward-looking implied volatility (IV).

Applying VIX Volatility to the Broader Market

The VIX was the first benchmark index introduced by CBOE to measure the market’s expectation of future volatility.

As a forward-looking index, it is constructed using the implied volatilities of S&P 500 index options and represents the market’s expectation of 30-day future volatility of the S&P 500 Index, which is considered the leading indicator of the broad U.S. stock market.

Introduced in 1993, the VIX is now an established and globally recognized gauge of U.S. equity market volatility. It is calculated in real time based on the live prices of the S&P 500 Index. Calculations are done, and values are shared from 3 a.m. to 9:15 a.m. and 9:30 a.m. to 4:15 p.m. EST. In April 2016, the CBOE started communicating the VIX outside of U.S. trading hours.

How VIX Values Are Calculated

VIX values are calculated using the CBOE-traded standard SPX options, which expire on the third Friday of each month, and the weekly SPX options, which expire on all other Fridays. Only SPX options are considered whose expiry period lies between 23 and 37 days.

While the formula is mathematically complex, it theoretically estimates the S&P 500 Index volatility by averaging the weighted prices of various SPX puts and calls across many strike prices.

All qualifying options need valid bid and ask prices to show market views on which strike prices will be met before expiry.

For detailed calculations with an example, one can refer to the section “The VIX Index Calculation: Step-by-Step” of the VIX white paper.

The History and Development of the VIX

In 1993, the VIX was first calculated using the implied volatility of eight S&P 100 at-the-money options. The derivatives market then had limited activity and was still growing.

As the derivatives markets matured, 10 years later, in 2003, the CBOE teamed up with Goldman Sachs and updated the methodology to calculate the VIX differently.

It then started using a wider set of options based on the broader S&P 500 Index, an expansion that allows for a more accurate view of investors’ expectations of future market volatility. A methodology was adopted that remains in effect and is also used for calculating various other variants of the volatility index.

Comparing VIX Movements With S&P 500 Trends

When the market falls, volatility values, investor fears, and the VIX levels rise. When the market rises, these values tend to drop. The price action of the S&P 500 and the VIX often shows inverse price action: when the S&P falls sharply, the VIX rises—and vice versa.

Trading Strategies for the VIX

The VIX has paved the way for using volatility as a tradable asset, albeit through derivative products. CBOE launched the first VIX-based exchange-traded futures contract in March 2004, followed by the launch of VIX options in February 2006.

Such VIX-linked instruments allow pure volatility exposure and have created a new asset class. Active traders, large institutional investors, and hedge fund managers use VIX-linked securities for portfolio diversification, as historical data demonstrate a strong negative correlation of volatility to the stock market returns—that is, when stock returns go down, volatility rises, and vice versa.

Like all indexes, one cannot trade the VIX directly. Instead, investors can take a position in VIX through futures or options contracts, or through VIX-based exchange-traded products (ETPs). For example, the ProShares VIX Short-Term Futures ETF (VIXY) and the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) are two such offerings that track a certain VIX-variant index and take positions in linked futures contracts.

Active traders who employ their own trading strategies and advanced algorithms use VIX values to price the derivatives, which are based on stocks with high beta. Beta represents how much a particular stock price can move with respect to the activity of the broader market index.

For instance, a stock with a beta of +1.5 indicates that it is theoretically 50% more volatile than the market. Traders making bets through options of such high beta stocks utilize the VIX volatility values in proportion to correctly price their options trades. Following the popularity of the VIX, the CBOE now offers several other variants for measuring broad market volatility.

Examples include the CBOE Short-Term Volatility Index (VIX9D), which reflects the nine-day expected volatility of the S&P 500 Index; the CBOE S&P 500 3-Month Volatility Index (VIX3M); and the CBOE S&P 500 6-Month Volatility Index (VIX6M).

Products based on other market indexes include the Nasdaq-100 Volatility Index (VXN); the CBOE DJIA Volatility Index (VXD); and the CBOE Russell 2000 Volatility Index (RVX).

The Bottom Line

The CBOE Volatility Index (VIX), often referred to as the "Fear Index," provides a benchmark for the market's future volatility expectations. It is a critical tool for investors and traders to assess market risk and sentiment, helping them make informed decisions. As the VIX tends to rise when markets decline and fall when they advance, it serves as an inverse indicator of market trends. While the index isn't tradable, investors can engage with VIX-linked products such as futures, options, ETFs, and ETNs to leverage its movements. Understanding VIX levels, particularly those above 30, which indicate high market volatility, can guide investors in hedging strategies and pricing derivatives.