One of the major investors’ instruments, CBOE Volatility Index (VIX) helps them analyze price fluctuations and predict the cost of stocks, options and other tradable assets. If you haven’t used it before, this guide will explain to you the basics of the VIX market level, ways to calculate it and make well-considered investment decisions.
The article covers the following subjects:
What Is the VIX (CBOE Volatility Index)?
For various markets, their own volatility measures were created: the VIX index — for the stock S&P 500, VXD — for the industrial Dow Jones Industrial Average, VXN — for the American technological Nasdaq Composite.
The Chicago Board Options Exchange (CBOE) began calculating VIX in the mid-’90s. The values of the index show how the expectations of market participants for a wide range of instruments are changing for the next thirty-day period. For the calculation, prices reflecting supply and demand for options on the S&P 500 index are taken — that allows getting an unbiased picture.
The VIX index shows investor sentiment through volatility. We can conclude either about calmness or about the beginning panic in connection with the future price dynamics in the market.
The VIX is also called the “fear index”: the higher it is, the stronger the panic (and volatility, respectively) in the market. At this time, investors prefer to dump risky assets and transfer their money into protective instruments.
How is the CBOE Volatility Index formed? The index value keeps in the range of 0-100. In fact, this is an indicator of the volatility of the stock markets, which is calculated based on the prices of options on the S&P 500 American market index.
How Does the VIX Work?
The VIX is inversely related to equity markets. The volatility index will rise in value when the stock market (primarily the S&P index) falls. When VIX index values rise above 40-45, it indicates that the level of fear in the market is growing, and investors are fleeing risk. If the value is near 17 or below, this is an indicator of calm trading and low risk. However, if the VIX falls too low, it is dangerous as everyone expects the upside to continue. At such moments, traders should be double-careful.
How Does the VIX Measure Market Volatility?
The level of less than 20 points shows the optimistic mood of market participants. However, despite the optimism and calmness, this often signifies a trend reversal, which means they need to close positions with risky instruments. 20-30 is an average level that does not indicate any significant changes.
If the level reaches 40 points or more, market participants are panicking. During this period, the world usually witnesses a collapse in the prices of stocks, currencies of developing countries and commodity assets. At the same time, such falls are considered the best time to buy risky assets. After all, when the situation gets corrected, their value will begin to rise. So, the analysis of the CBOE Volatility Index helps the investor understand how the trend is developing and when to fix their positions, as well as determine the most appropriate entry and exit points for their deals.
Historical volatility shows the asset’s price changes over a particular timeline. By measuring implied volatility (aka future volatility), a trader can predict the upcoming price range. Note that VIX also helps traders measure the future changes of correlating indicators, such as SPX.
How to calculate VIX
The Volatility Index value is a generalized assumption based on the price of premiums that investors are willing to pay for the right to buy or sell an option on the S&P 500 Index. Thus, the VIX is the weighted average of all option prices in the S&P 500 Index.
The VIX values are measured as a percentage and are approximated to the movement that is expected in the S&P 500 Index over the next 30 calendar days, after which it is recalculated for a year. So, if the value of VIX is 15, this is 15% of the expected annual change.
The full formula for calculation of VIX index looks pretty complicated:
VIX is calculated as the square root of the value of the swap rate fluctuation for 30 days starting today. Note that the VIX is the volatility of the swap change, not the volatility of the swap (volatility that is the square root of the change or standard deviation). Swap change can be fully statically duplicated through simple put and call, while swap volatility requires dynamic hedging. VIX is the square root of the risk-neutral expectation of fluctuations in the S&P 500 over the next 30 calendar days. The VIX is quoted at the annualized standard deviation.
For the calculation, options with a maturity of 23-27 days are used. The VIX volatility value is multiplied by 100. For example, if the VIX is 20, this implies 20% volatility.
The VIX replaces the older VXO as the preferred volatility index used by the media. VXO was a measure of implied volatility calculated using 30-day options on the S&P 100 Index.
How to Invest in the CBOE Volatility Index?
This is a sector-specific index: traders are using VIX with options and futures — each comes with different risks:
Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN (VXX) is the most common option. This is an IOU from Barclays, which mirrors the two closest expiration VIX futures. A significant drawback of the VXX is that its dynamics with the approaching expiration may not coincide with the dynamics of the VIX. This is due to this contango effect when the nearest futures are cheaper than the distant ones. Therefore, this instrument is not suitable for a long-term position. However, there is also a positive point: the VXX stocks correlate negatively with the S&P 500, which may become a chance to capitalize on the increased volatility in the event of a market crash.
ProShares Ultra VIX Short-Term Futures ETF (UVXY) is a paper with a hard-wired 2:1 leverage effect. This is the best option in terms of liquidity and short-term tracking. If the underlying asset index rises 1%, UVXY adds 2% and vice versa. However, the stock reflects the dynamics of the VIX inaccurately (due to contango), which is also risky.
Futures on VIX repeat the dynamics of the VIX index as closely as possible and have a leverage effect. However, they are not very convenient due to expiration: you have to shift your hands or additionally buy calendar spreads on them. Operations with options are more complicated and require careful research.
Alternatively, you can trade the VIX with such derivatives as:
VIX exchange options;
Short-term futures VIX S&P 500 ETN (NYSE: VXX) and temporary futures VIX S&P 500 ETN (NYSE: VXZ);
VIX S&P 500 ETF (LSE: VIXS) launched by Source UK Services in June 2010;
Short-term futures VIX ETF (NYSE: VIXY) and temporary futures VIX ETF (NYSE: VIXM) launched by ProShares in January 2011.
How to trade VIX?
Based on the values of the market volatility index, trading strategists have derived a few rules for trading stock assets:
The growth of the VIX indicates a panic in the market. Investors are dumping stocks, you need to prepare to buy good assets in the near term.
When the VIX market index consolidates above 40-45% values, you can open buy deals with the aim of long-term growth.
A decline in the VIX is a sign of investors’ calm mood. They prefer to buy up shares, pushing their price upward, towards overbought. It is necessary to look closely at sales, as well as fix profits on long positions.
Long-term short positions can be opened after the VIX index consolidates below 20.
The VIX Examples
To start with, let’s review the example of the CBOE Volatility Index indicating panic on the stock market.
The Chicago Board Options Exchange introduced the index in 1993. The maximum value of the index at 89.53 was recorded on October 24, 2008 during the recession. Minimum (8.56) — November 24, 2017. Most of the time, the index value kept in the range between 15 to 40. If the VIX is below 20 or 15, investors’ concerns are minimal.
VIX values below 20 means that the markets are steadily growing, and the very decline of the VIX to this level can be perceived as a good opportunity for quiet buying. If the VIX value is above 70–80, this indicates a high level of fear of investors who are trying to insure themselves as much as possible from price fluctuations and recessions. The index, however, should not be used as an unambiguous signal to buy or sell. Another example will explain why.
For financial instruments such as stocks, volatility is a statistical measure of the degree to which their trading price has changed over some time. On September 27, 2018, Texas Instruments Inc. (TXN) and Eli Lilly & Co. (LLY) closed near similar price levels of $107.29 and $106.89 per share, respectively. However, an analysis of their price movements over the last month (September) shows that TXN price fluctuations (blue graph) were much wider compared to LLY price fluctuations (orange graph). TXN had higher volatility compared to LLY for one month.
When observing the 3 months (from July to September) of price changes, we can see a reversal of the trend: LLY had a much wider range of price fluctuations compared to TXN, which is completely different from the near-term observation made in one month. LLY had higher volatility than TXN over the three-month period.
The VIX index is a must-have in traders’ arsenal of instruments. It helps investors see asset price performance and identify its current trend. What’s more, VIX correlates with other indicators and can help analysts predict the direction of their movement (which can be the opposite of VIX). Although the process of calculation is complicated, you don’t have to do it manually — the majority of trading terminals support this instrument and indicate volatility index.
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