CBOE Volatility Index (VIX) Explained

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When Averages Lie: VIX and CAPE

The historical average for VIX is 19. When the market is calm, “normal”, VIX is usually much lower, like 12–15. But since the historical average is 19, people expect VIX to return to the average level — you can easily see it on VIX futures term structure.

Ok, VIX will someday spike and return to the average, but the question is how long you have to wait for this. From my research, there’s no point to expect mean-reverting behaviour from VIX. You best assumption about close-future VIX is that it will stay the same as it is now. If it mean-reverts, it happens on much longer time-frame than the term structure implies.

Calm, “normal” markets show low VIX, but sometimes things happen and VIX spikes, that is why the average VIX is significantly higher than “market-normal” levels. But from the fact that something bad can happen, you cannot draw conclusions about the closest VIX behaviour. Yes, something bad will surely happen someday in future, but you can’t know when. Most probably not tomorrow. Not anytime soon.

So when you truly believe in VIX mean-reverting behaviour, you will probably end up doing expensive things too early.

I strongly suspect that the same thing applies to CAPE (Shiller’s P/E). When conditions are somewhat to be called “normal”, maybe that’s ok for markets to have CAPE above 20. And only when markets are stressed when something bad happens with the economy, only then CAPE goes significantly lower, which makes historical average float around 15.

Let’s assume we have a “normal” market today, with CAPE higher than average, should we worry about high CAPE? Can we draw conclusions from the fact, that in US stock market history there were events that draw CAPE much lower than a “normal” level? Should we expect the stock market to go down soon just because something bad can happen someday?

If we consider CAPE case to be something like VIX case, the answer is no. Your best bet about the normal market is that it will continue to be normal. Yes, normal markets end someday, when some really nasty problems come out. But it can be very expensive to expect it to happen tomorrow. Or anytime soon.

CBOE Volatility Index (VIX) Definition

What Is the CBOE Volatility Index (VIX)?

Created by the Chicago Board Options Exchange (CBOE), the Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments. It is also known by other names like “Fear Gauge” or “Fear Index.” Investors, research analysts and portfolio managers look to VIX values as a way to measure market risk, fear and stress before they take investment decisions.

Key Takeaways

  • The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days.
  • Investors use the VIX to measure the level of risk, fear, or stress in the market when making investment decisions.
  • Traders can also trade the VIX using a variety of options and exchange-traded products, or use VIX values to price derivatives.

How Does the VIX Work?

For financial instruments like stocks, volatility is a statistical measure of the degree of variation in their trading price observed over a period of time. On 27 September 2020, shares of Texas Instruments Inc. (TXN) and Eli Lilly & Co. (LLY) closed around similar price levels of $107.29 and $106.89 per share, respectively. However, a look at their price movements over the past one month (September) indicates that TXN (Blue Graph) had much wider price swings compared to that of LLY (Orange Graph). TXN had higher volatility compared to LLY over the one-month period.

Extending the observation period to last three months (July to September) reverses the trend: LLY had much wider range for price swings compared to that of TXN, which is completely different from the earlier observation made over one month. LLY had higher volatility than TXN during the three month period.

Volatility attempts to measure such magnitude of price movements that a financial instrument experiences over a certain period of time. The more dramatic the price swings are in that instrument, the higher the level of volatility, and vice versa.

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How Volatility is Measured

Volatility can be measured using two different methods. First is based on performing statistical calculations on the historical prices over a specific time period. This process involves computing various statistical numbers, like mean (average), variance and finally the standard deviation on the historical price data sets. The resulting value of standard deviation is a measure of risk or volatility. In spreadsheet programs like MS Excel, it can be directly computed using the STDEVP() function applied on the range of stock prices. However, standard deviation method is based on lots of assumptions and may not be an accurate measure of volatility. Since it is based on past prices, the resulting figure is called “realized volatility” or “historical volatility (HV).” To predict future volatility for the next X months, a commonly followed approach is to calculate it for the past recent X months and expect that the same pattern will follow.

The second method to measure volatility involves inferring its value as implied by option 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). For example, say IBM stock is currently trading at a price of $151 per share. There is a call option on IBM with a strike price of $160 and has one month to expiry. The price of such a call option will depend upon the market perceived probability of IBM stock price moving from current level of $151 to above the strike price of $160 within the one month remaining to expiry. Since the possibility of such price moves happening within the given time frame are represented by the volatility factor, various option pricing methods (like Black Scholes model) include volatility as an integral input parameter. Since option prices are available in the open market, they can be used to derive the volatility of the underlying security (IBM stock in this case). Such volatility, as implied by or inferred from market prices, is called forward looking “implied volatility (IV).”

Though none of the methods is perfect as both have their own pros and cons as well as varying underlying assumptions, they both give similar results for volatility calculation that lie in a close range.

Extending Volatility to Market Level

In the world of investments, volatility is an indicator of how big (or small) moves a stock price, a sector-specific index, or a market-level index makes, and it represents how much risk is associated with the particular security, sector or market. The above stock-specific example of TXN and LLY can be extended to sector-level or market-level. If the same observation is applied on the price moves of a sector-specific index, say the NASDAQ Bank Index (BANK) which comprises of more than 300 banking and financial services stocks, one can assess the realized volatility of the overall banking sector. Extending it to the price observations of the broader market level index, like the S&P 500 index, will offer a peek into volatility of the larger market. Similar results can be achieved by deducing the implied volatility from the option prices of the corresponding index.

Having a standard quantitative measure for volatility makes it easy to compare the possible price moves and the risk associated with different securities, sectors and markets.

The VIX Index is the first benchmark index introduced by the CBOE to measure the market’s expectation of future volatility. Being a forward looking index, it is constructed using the implied volatilities on S&P 500 index options (SPX) 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 Index 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 S&P 500 index. Calculations are performed and values are relayed during 2:15 a.m. CT and 8:15 a.m. CT, and between 8:30 a.m. CT and 3:15 p.m. CT. CBOE began dissemination of the VIX Index outside of U.S. trading hours in April 2020.

Calculation of VIX Index Values

VIX index values are calculated using the CBOE-traded standard SPX options (that expire on the third Friday of each month) and using the weekly SPX options (that expire on all other Fridays). Only those SPX options are considered whose expiry period lies within 23 days and 37 days.

While the formula is mathematically complex, theoretically it works as follows. It estimates the expected volatility of the S&P 500 index by aggregating the weighted prices of multiple SPX puts and calls over a wide range of strike prices. All such qualifying options should have valid non-zero bid and ask prices that represent the market perception of which options’ strike prices will be hit by the underlying during the remaining time to expiry. For detailed calculations with example, one can refer to the section “VIX Index Calculation: Step-by-Step” of the VIX whitepaper.

Evolution of VIX

During its origin in 1993, VIX was calculated as a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options, when the derivatives market had limited activity and was in growing stages. As the derivatives markets matured, ten years later in 2003, CBOE teamed up with Goldman Sachs and updated the methodology to calculate VIX differently. It then started using a wider set of options based on the broader S&P 500 index, an expansion which allows for a more accurate view of investors’ expectations on future market volatility. The then adopted methodology continues to remain in effect, and is also used for calculating various other variants of volatility index.

Real World Example of the VIX

Volatility value, investors’ fear and the VIX index values move up when the market is falling. The reverse is true when market advances – the index values, fear and volatility decline.

A real world comparative study of the past records since 1990 reveals several instances when the overall market, represented by S&P 500 index (Orange Graph) spiked leading to the VIX values (Blue Graph) going down around the same time, and vice versa.

One should also note that VIX movement is much more than that observed in the index. For example, when S&P 500 declined around 15% between August 1, 2008 and October 1, 2008, the corresponding rise in VIX was nearly 260%.

In absolute terms, VIX values greater than 30 are generally linked to a large volatility resulting from increased uncertainty, risk and investors’ fear. VIX values below 20 generally correspond to stable, stress-free periods in the markets.

How to Trade the VIX

VIX index has paved the way for using volatility as a tradable asset, although through derivative products. CBOE launched the first VIX-based exchange-traded futures contract in March 2004, which was 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 altogether. Active traders, large institutional investors and hedge fund managers use the VIX-linked securities for portfolio diversification, as historical data demonstrates a strong negative correlation of volatility to the stock market returns – that is, when stock returns go down, volatility rises and vice versa.

Other than the standard VIX index, CBOE also offers several other variants for measuring broad market volatility. Other similar indexes include the Cboe ShortTerm Volatility Index (VXSTSM) – which reflects 9-day expected volatility of the S&P 500 Index, the Cboe S&P 500 3-Month Volatility Index (VXVSM) and the Cboe S&P 500 6-Month Volatility Index (VXMTSM). Products based on other market indexes include the Nasdaq-100 Volatility Index (VXNSM), Cboe DJIA Volatility Index (VXDSM) and the Cboe Russell 2000 Volatility Index (RVXSM). Options and futures based on RVXSM are available for trading on CBOE and CFE platforms, respectively.

Like all indexes, one cannot buy the VIX directly. Instead investors can take position in VIX through futures or options contracts, or through VIX-based exchange-traded products (ETP). For example, ProShares VIX Short-Term Futures ETF (VIXY), iPath Series B S&P 500 VIX Short Term Futures ETN (VXXB) and VelocityShares Daily Long VIX Short-Term ETN (VIIX) are many such offerings which track certain VIX-variant index and take positions in linked futures contracts.

Active traders who employ their own trading strategies as well as advanced algorithms use VIX values to price the derivatives which are based on high beta stocks. Beta represents how much a particular stock price can move with respect to the move in broader market index. For instance, a stock having 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 appropriate proportion to correctly price their option trades.

CBOE Volatility Index (VIX) Explained

VIX is an index measuring the expected level of volatility in the US stock market over the next 30 days.

VIX – Introduction

Why Does Volatility Matter?

One could never understand the significance of the VIX without first understanding what volatility is. Volatility is defined as “Tendency to fluctuate Sharply & Regularly” at dictionary.com. Hence the saying,”A volatile market”. Volatile markets are characterized by wild swings with big up days followed by sudden sharp drops. Volatile market conditions makes it extremely hard for traders and investors to decide if it is time to take profit or cut losses as stocks could suddenly resume bullishness or collaspe. Volatility affects options trading as well. Higher volatility means higher options premiums, making it extremely disadvantageous to execute debit options strategies. Higher options premium also mean a much higher breakeven point for every debit options strategies, making it harder for them to make money. On the other hand, higher volatility also makes credit options strategies or Covered Calls extremely profitable as there are now much more extrinsic value to profit from. Without a means to measure the level of volatility in the market, options traders would not be able to make a completely educated decision on the options strategy to use for the prevailing circumstances.

This is why being able to quantify and measure volatility is so important in options trading and what makes the VIX so essential.

History Of The VIX

Calculation for the VIX was first introduced in 1993 by the Chicago Board of Exchange (CBOE) and have gone through one major change to its algorithm. In 2004, futures trading was enabled on the VIX and in 2006, VIX options was launched. These derivatives enabled traders to trade and hedge against volatility for the first ever time.

Interpreting The VIX

The VIX is quoted as a percentage estimating the implied volatility of the market, which is the expected annualized movement of the S&P-500 over the next 30 days. Not to get too technical, when the VIX is at 30, it means that the S&P-500 might move as much as 2.5% (30% divided by 12 months. There is some contention here about whether it should be divided by 12 or should it be a discounted value taking into consideration compounding. Either way, there is no need to complicate things as both methods are not known to produce an exact prediction of how much the S&P500 will move in a month. As traders, not academics, we focus on what the number suggests. Hence the more straight forward method is presented here.) up or down over the next 30 days.

When the market is trending steadily upwards, there is generally a low level of volatility in the market as complacency sets in and more call options are bought than put options. Conversely, when a market is falling, there is generally widespread panic in the market causing a high level of volatility as more put options are bought than call options. This correlation is also why the Put Call Ratio is read in conjunction with the VIX to provide more insight into the state of volatility in the market. Together, the Put Call Ratio and the VIX have been known as “investor fear gauges”.

When the US stock market enters a sharp correction in January 2008, the VIX also spiked to a multi-year high of over 37. Conversely, when the US stock market was at the height of its bull run in 2006, VIX was as low as 8.6, which again was a multi-year low. The correlation between the VIX and the state of the market is uncanny. This is why the VIX is useful not only for options traders as stock traders and investors also use the VIX as a market timing devise or a contrarian indicator.

As a contrarian indicator, the higher the VIX, the more bearish the market is and conversely, the lower the VIX, the more bullish the market is.

Extreme readings in the VIX has also been used as a reversal indicator. Ever since the VIX spiked over 37 in January of 2008, the US stock market bottomed out and staged a recovery. Similarly, when the VIX bottomed at 8.6 in 2006, the US stock market slowed down in 2007 and then corrected sharply.

VIX is also a direct indication of the level of implied volatility in the options market. The higher the VIX, the more profitable credit spreads and naked writes become due to the fact that all options contains relative higher extrinsic value than when the VIX is low. Options traders could therefore change options strategies as the market conditions change, favoring debit spreads when the VIX is low and credit spreads when the VIX is high.

The real question now is, when is the VIX high or low?

There really isn’t a standard to what constitutes a high or low VIX reading. Apart from using your experience and gut feel, there are 2 main ways to read the VIX. 1, Multi-years high or low. 2, VIX trend.

Multi-year highs or lows typically warns investors that turning points may be near. The above examples marked two market reversals when the VIX was in multi-year high and low. Investors and traders may consider covering or closing profitable positions when these points are reached.

The trend of the VIX also provides an indication to the trend of the stock market. In a bull market, the VIX is typically trending downwards and in a bear market, the VIX is typically trending upwards. The VIX was trending downwards steadily in the big bull run of 2003 to 2006.

You can see the daily VIX chart from our Option Trader’s HQ.

How Is The VIX Calculated?

The calculation for the VIX underwent a major change since September 2003. The original VIX (now known as VXO) was calculated by averaging the implied volatility of at the money (ATM) options of the S&P 100 (OEX) using the Black-Scholes Model. There were obviously too many flaws in the original VIX calculation as the OEX, comprising only 100 stocks, cannot be taken as the closest representation of the stock market and implied volatility derived through the Black-Scholes Model are littered with flaws inherent in the Black-Scholes Model itself.

The new VIX calculation, which results in the present VIX, estimates implied volatility by a weighted average of a wide range of strike prices in the S&P-500 using a newly developed formula which is independant of any currently known models. In fact, just by switching to using the S&P-500 instead of the S&P-100, the VIX much more correlated to actual market volatility, increasing the value of VIX futures and VIX options as hedging tools. Using a range of strike prices rather than just at the money options also acknowledges the difference in implied volatility across different strike prices (the volatility smile).

To arrive at the VIX value, a wide range of In The Money to Out Of The Money call options and put options of two expiration months bracketing the nearest 30-day period are selected. The implied volatility of all options of each of the selected months are estimated on a price weighted average basis in order to arrive at a single average implied volatility value for each month. Finally, results of the two months are interpolated using a 30 days constant and then a percentage derived from the square root of that result.

VIX Variants – VXN & VXD

Apart from the VIX and the VXO, volatility index is also calculated for the NASDAQ 100, going by the ticker symbol VXN as well as for the Dow Jones Industrial Average, going by the ticker symbol VXD. The VXN, short for CBOE NASDAQ-100 Volatility Index, and the VXD, short for CBOE DJIA Volatility Index, use the same formula for the VIX and applies it to the NDX (NASDAQ 100 index) and DJ-30 (Dow Jones Industrial Average). They work exactly the same way as the VIX and can be interpreted in the exact same manner. Futures and Options are also available for both the VXN and VXD, allowing sector or industry specific investors and traders to hedge volatility risk directly.

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