What is the volatility index (VIX) – What you should know?

The volatility index (VIX) was created by the Chicago Board Options Exchange (CBOE) in 1993. It started by measuring the implied volatility of eight S&P 100 options when the derivatives market wasn’t easily accessible but still growing.

It wasn’t until 2003 when the CBOE partnered with Goldman Sachs to update how the VIX had been calculated to start using a wider set of options based on the more extensive S&P 500.

The VIX is a real-time indicator that tracks the expectations of near-term price changes of the S&P 500 index, also known as the US 500 index or SPX. It tracks the performance of the stocks of 500 large-cap companies in the US.

The S&P 500 is used because it represents about 80% of the value of US stocks.

The volatility index is forward-looking because it gathers the option prices from the S&P 500 and generates the suggested volatility for the next 30 days.

Options prices could be considered a good measurement of volatility because when traders and investors start seeing concerns in the market, they might start buying more options, potentially raising prices. That’s why the VIX is also known as the “fear index” or “fear gauge”; it ultimately measures the level of market fear, stress, uncertainty, and sentiment.

Apart from the volatility index being inversely related to the S&P 500, many traders and investors might also use it to gain perspective on the potential volatility of the broader US stock market.

The VIX index measures the price of S&P 500 index options with short-term expiration dates. This means that the expected level of volatility shown on the VIX is not based on the current value of the S&P 500 itself but rather on the price at which traders and investors are willing to buy and sell the SPX options in the coming month.

As previously mentioned, the VIX is inversely related to the S&P 500 index. This means that, generally, when the volatility is high, indicating uncertainty and fear among traders and investors, the price of the S&P 500 decreases. Conversely, when the volatility on the VIX is low, it indicates more confidence from market participants, which in turn increases the price of the S&P 500.

There are different levels of volatility, which could be interpreted as follows:

• When the level is below 15, it indicates low volatility and optimism among many market participants.
• A level between 15 and 25 indicates an increase in volatility but is considered normal for financial markets.
• A level between 25 and 30 indicates a rising increase in volatility and a certain degree of uncertainty among market participants.
• Levels of 30 and above indicate significant volatility, resulting in higher degrees of uncertainty and fear among market participants.

Having a solid understanding of the VIX and the various factors surrounding it could assist both investors and traders in gaining a sense of market sentiment, which could also help with making trading decisions.

In the next section, we’ll examine the factors influencing volatility.

While the VIX index could be an essential tool for identifying market volatility levels, several factors can influence it, and understanding those factors might be essential for those looking to incorporate this index into their overall trading or investment strategy.

Below is an in-depth breakdown of those factors:

• Economic data: Certain economic data reports, such as GDP, inflation, unemployment rate, or Non-Farm Payrolls (NFP) reports, can affect the VIX; depending on whether they’re negative or positive, the VIX can either increase or decrease. For example, if the US Department of Labour releases a strong jobs report, that could be seen as positive, as there is an increase in new jobs, which could strengthen the economy and decrease volatility. However, if the jobs report is weaker, it could be seen as unfavourable, which might increase volatility.
• Options trading activity: When options trading activity increases, it generally tends to increase the VIX; when it decreases, it generally tends to decrease the VIX as well. This is because buying options is seen as buying insurance against market volatility. So, when the price of options increases, so does the VIX, and when it decreases, the VIX follows.
• Market sentiment: When there is a lot of positive activity in the market, investors could become more optimistic, which might lead to lower volatility levels on the VIX. Conversely, if the market is showing uncertainty, investors could become more pessimistic, which might then lead to an increase in volatility.
• Political events: During specific political events such as presidential elections, government policy changes, or geopolitical events could impact the VIX. For example, the upcoming 2024 US presidential election could see the VIX increase during the months leading up to the November voting date as investors keep an eye on various factors surrounding the US elections, such as possible monetary policy updates from each candidate as well as different sectors and industries that could be affected. Below is a chart showing how the US presidential election could affect the VIX.

Source: CNBC

• Global events: Global events bring a lot of uncertainty into the market, which is why they could significantly impact the VIX. For example, some of the more significant events that saw a spike in the VIX include the dot-com bubble, which occurred in 1998 and lasted until 2000. There was also the 2008 global financial crisis, the 2012 SARS outbreak, and the 2020 COVID-19 pandemic. Below is a chart showing exactly how the VIX responded to these events.

Source: CNBC

• Interest rates: Another factor that could impact the VIX is interest rates. When interest rates are low, volatility generally increases, whereas when they are high, volatility generally decreases. This is because when interest rates are low, investors and traders become more optimistic about the economy and participate more in the financial markets, where some might also take on more riskier investments.

The VIX calculates the volatility levels by using S&P 500 index options that expire on the third Friday of each month and those that expire on different Fridays within the same period. The VIX index only considers options that expire between 23 and 37 days, presenting the implied 30-day volatility of the S&P 500, as previously mentioned.

The formula itself could be complicated, as seen in the picture below. However, it’s not necessary to know the exact mathematical calculations in order to use the volatility index.

The basic theory of the VIX calculations states that by combining the prices of various S&P 500 put and call options over a broad range of strike prices, traders are able to gain a better insight into what prices market participants are willing to buy and sell the S&P 500 at. These valuations provide a better understanding of the possible future volatility of the S&P 500.

Those options that qualify are at the money, meaning they indicate market expectations about which strike prices are likely to be reached before expiration. This information then reflects the broader market sentiment of the potential future direction of the S&P 500.

The volatility calculations are updated in real-time during trading hours: from 8 am to 2:15 am (UTC), which is 9:00 am (GMT +1) to 3:15 am (GMT +1), and again from 2:30 am to 9:15 pm (UTC), which is 3:30 am (GMT +1) to 10:15 pm (GMT +1).

The VIX could be used as part of a trader’s trading strategy. The level of volatility on the VIX could indicate whether the S&P 500 or broader stock market might reverse or continue in its current trend.

As previously mentioned, generally, when the volatility index is increasing, it could be seen as a time to look for possible short (sell) positions as the market might be moving downwards. Conversely, when the index decreases, it could be seen as a time to look for possible long (buy) positions as the market might be moving upwards.

As a side note, even though the VIX is directly related to the US stock market, more specifically the S&P 500, it could also assist when trading the forex market. When the volatility is high, it could be associated with a stronger dollar as investors close their positions and look for “safe haven” currencies.

Conversely, low volatility could lead to a weaker dollar as investors might move their capital into riskier assets. That said, if the higher levels of volatility are directed at the dollar, for example, if investors are showing concerns about the US economy, those concerns could weaken the dollar.

Now, it might be essential to keep in mind that the VIX can stay high or low for quite some time, so it could be challenging to rely solely on it when looking for possible trading opportunities and signals.

It might be better to combine the volatility index with various fundamental analysis and technical analysis indicators to confirm possible entry points further.

Below is a chart comparing the VIX and the S&P 500 from 1998 until now. It’s marked up, showing the areas where the VIX increased and the S&P 500 decreased, as well as the areas where the VIX decreased while the S&P 500 increased.

Source: CNBC

It’s possible to trade the VIX through derivative products such as options, futures, CFDs, spread betting, or even VIX-based exchange-traded funds. When trading the VIX in this manner, a trader will only speculate on whether they predict the index will go up or down and open positions accordingly instead of using it to measure the market's volatility.

Traders could also use the VIX as part of their hedging strategy, seeing as it’s inversely related to the S&P 500, in order to possibly balance out their portfolio depending on the direction the VIX moves.

For example, let’s say a trader has a long (buy) position open on a stock related to the S&P 500. However, their analysis predicts the stock will decrease in value. They could then open a long (buy) position on the VIX with an expectation that it will possibly rise.

If their prediction was correct and they closed their position in profit, it would balance out their losses from their original trade. If the prediction was incorrect and they closed the position at a loss, it would still be mitigated by the profits they made from their original position.