VIX is a ticker symbol of the Chicago Board Exchange Volatility Index (CBOE). The index represents the expectation of the market volatility in next 30 days. It is developed using the implied volatilities of multiple S&P 500 index options. The volatility index is a popular metric that is used to gauge the market risk. Most industry experts call this metric as ‘investor fear gauge’.
Characteristics of COBE Volatility Index – VIX
Developed by Professor Dan Galai and Professor Menachem Brenner in 1986, VIX is based on the weighted prices of different options listed in the S&P 500 index. Investors can trade in VIX options contracts whose performance are based on the current market prices of all call and put having first and second month expiration.
COBE calculates VIX index by taking the square root of the variance swap rate having 30 days duration. The resulting value represents the volatility of the variance swap, and not a volatility swap that is another concept.
Prior to the introduction of VIX, most industry experts used VXO that calculated the volatility using 30-day at-the-money options included in the S&P 100 index. However, the VXO value did not accurately reflected the volatility of the market. As a result, most financial pundits replaced the index with VIX.
How Investors Can Use VIX to Interpret Market Volatility
VIX is quoted in percentage term rather than in values. Investors can use this index as a guide to estimate the future movement of prices during the next 30 days. Though VIX is commonly known as a fear index, it does not point to a bearish trend in the market.
What the volatility index does is measure the perceived volatility of the market. This volatility can be either in upward or downward direction. When the VIX shows high volatility in the upcoming weeks, most investors avoid selling the call stock option unless they receive a high premium for it. Similarly, investors are willing to pay a high premium for the call option in case VIX reflects high volatility.
High VIX shows that investors view considerable risk in the ensuing weeks that can be due to sharp movement of prices either in upward or downward direction. On the other hand, a low VIX reflects that the investors do not anticipate a high risk and that the market prices will not experience a high volatility.
Drawbacks of Using VIX to Gauge Market Volatility
Most experts regard VIX to be the benchmark of volatility in the market. However, a few scholars have criticized the metric saying that it in fact represents present market sentiment instead of reflecting future volatility. Another criticism of the CBOE volatility index is that it does not measure the actual expectations of volatility, and particularly when the market return is skewed. This means that investors should not use the VIX as the only tool to gauge market volatility but conduct fundamental analysis before making investment decisions.
Further Reading
- The VIX, the variance premium and stock market volatility – www.sciencedirect.com [PDF]
- The jump component of S&P 500 volatility and the VIX index – www.sciencedirect.com [PDF]
- Predicting regime switches in the VIX index with macroeconomic variables – www.tandfonline.com [PDF]
- Are VIX futures prices predictable? An empirical investigation – www.sciencedirect.com [PDF]
- Does VIX or volume improve GARCH volatility forecasts? – www.tandfonline.com [PDF]
- Using VIX data to enhance technical trading signals – www.tandfonline.com [PDF]
- The economic value of VIX ETPs – www.sciencedirect.com [PDF]
- Hedging the black swan: Conditional heteroskedasticity and tail dependence in S&P500 and VIX – www.sciencedirect.com [PDF]
