What is the VIX, or Volatility Index, and How Does It Work?

What is Vix or Volatility Index?

The VIX is sometimes referred to as “the fear index” for the stock market and investors can use the VIX to help gauge the level of risk, fear, and stress in the market which can aid in making trading decisions. It is one of the more famous stock market indicators in the world.

VIX stands for Volatility Index, and it was created by CBOE Global Markets who own the Chicago Board Options Exchange (CBOE).

The VIX is a real-time indicator representing the market's expectations for volatility over the coming 30 days. It uses the options market to calculate the implied volatility of the S&P 500. But investors around the world will pay attention to the VIX because the S&P 500 is one of the main proxies for the US stock market overall. So any tools that can help investors analyze markets as a whole is widely watched.

Investors can use the VIX to gauge market risk, fear, and stress when they are assessing trading opportunities. Some traders will also trade securities that are linked to the VIX index itself. For example, when bad news hits, the VIX can jump up sharply. Investors can use exchange-traded securities linked to the VIX, or even options and futures linked to the VIX. They can used these securities to hedge against risk, or to profit from changes in market sentiment.

While the formula for calculating the VIX is complex, the output is simple: it’s a number that can range from 0 to 100, and the higher it is, the more expectation of volatility the market has.

What is Volatility?

In the financial world, volatility refers to how much a security’s price fluctuates. The more it fluctuates, the higher the volatility. And remember, volatility can work both ways – prices can fluctuate higher or lower. But there are three main types of volatility you should be familiar with as a trader: standard deviation, beta, and implied volatility.

Standard deviation: This is a statistical measure of volatility. A security or index will have a higher standard deviation the more its price has fluctuated over a given period.

Beta: This on the other hand, calculates the volatility of an individual security in relation to the market. A security that has the same level of fluctuation in price as the market has a beta of 1. A security that is 20% more volatile than the market has a beta of 1.2, and conversely a security that has half the volatility of the market has a beta of 0.5.

Both standard deviation and beta are calculated based on previous performance.

Implied volatility:  This is an estimate of future volatility based on the price of options of a security or index. This is because option prices are largely tied to how volatile an underlying security are expected to be. The more volatile a security, the more likely it will hit its strike price, and hence, the price of the option (the premium) will reflect this. So when option prices increase, it generally means that the expectation of volatility for the underlying securities are increasing as well. This is important information for traders.

How does the VIX work?

You’ll find many guides that categorize levels of the VIX, but they are all subjective. Generally, a higher volatility index level signals greater uncertainty about prices in the next 30 days, but these are current investor expectations, and it doesn’t mean the markets will play out accordingly. The VIX can change rapidly.

Generally, a VIX reading of

• 0-12 could be associated with low expected volatility, while a VIX index reading of
• 12-20 might be associated with medium expected volatility, and VIX levels of
• 20 or above might be associated with high expected volatility.

For reference, the highest closing VIX levels during two of the scariest moments for investors in recent history, the Great Financial Crisis, and the onset of the COVID-19 pandemic, registered at 80.74 and 82.69, respectively. These periods were characterized by immense volatility in markets all over the world.

How is the VIX Index calculated?

Calculating the VIX is a complex procedure, here’s our step-by-step guide and a white paper published by the creator of the index, CBOE Global Markets, here. 

How to calculate the VIX

• Choose the options that you’d like to include in your VIX calculation. This should include your range call and put strikes in two consecutive expirations around the target 30-day mark.
• Calculate each option’s contribution to the total variance of its expiration.
• Sum up the contributions to receive the total variances of the first and second expiration.
• Then calculate the 30-day variance by interpolating the two variances, depending on the time to expiration of each.
• Take the square root to get volatility as standard deviation.
• Multiply the volatility (standard deviation) by 100.

Congratulations, you’ve found the VIX Index Value.

Understanding and effectively utilizing the VIX can offer traders an edge in market prediction and risk management. The VIX provides a measure of market risk and sentiment that can help in making informed trading decisions. Always remember, while the VIX can be a helpful tool in your investment arsenal, it should not be the sole indicator guiding your investment decisions.