With increasing numbers of people pouring into the markets, trying to take advantage of the current state of the world to get involved with day trading, you may have heard about the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), most commonly called simply “the VIX” for short. Broadly, it is the “fear gauge” or “fear index” aimed at trying to give users an insight into the broader feeling of the market. When the market is concerned, afraid, or otherwise worried, the VIX rises. If people are confident and calm, the VIX goes downward.
The VIX, as with most volatility indexes, is measured in percentage points.
When the VIX is high, this means many traders think the market is broadly going to get worse. If the VIX is low, that means traders think the market is going to get better. A low VIX is often in the 10s to the low 20s, with the lowest reading ever recorded being at around a 9. A high VIX reading can end up going much higher, topping 80 in both the 2008 and 2020 economic crises. A range between about 18 and 35 is “normal.”
Broadly, the VIX has an inverse relation with the S&P 500, the index representing the 500 large companies that are used to approximate the American market; when one index goes up, the other is likely going down. As a piece of information, this can help to gauge how bad a particular shock to the market is, as a skyrocketing VIX means a lot of downward movement in stocks, suggesting people do not want to remain in unprotected positions.
In the absolute simplest interpretation, a high VIX means you may want to consider liquidating your positions or preparing to hold through some bad times, while a lower VIX means you can continue business as usual. A common strategy for non-institutional investors has been to buy while the VIX is high and sell while it is low. Pursuing that strategy during the crash of 2020 could have resulted in significant returns. Regardless of your strategy, the VIX has historically been among the best tools for determining short-term market volatility.
CBOE Volatility Index In Depth
Although a broad understanding of the VIX can be sufficient for many traders, delving into the specifics can provide additional insight, particularly for the understanding of marketing conditions during volatile markets.
As a volatility index, the aim of the VIX is to provide a mathematical representation of the implied volatility of the S&P 500 options markets over a 30-day period. That figure is tricky to break down and does not answer all of our questions. Because the VIX is an index based upon options rather than stocks or other assets, the index is more about market perceptions than anything.
The S&P 500 is a shorthand for a certain portion of the larger economic system. Through some abstraction, this means the performance of the S&P 500 is an indicator of the situation of the larger market. Individuals are able to invest in and buy stocks from the S&P 500 index, functionally buying into the health of the economy as a whole. Additionally, many people trade options for the S&P, functionally betting on the larger trends in the market and the state of the American economy. When more people are buying more options, whether as a measure of protection for their investments or as a larger buy in the market, option prices go up.
These rising prices feed into the models used to calculate the VIX. When more people are buying more options, often at higher prices, the VIX gets driven up. The VIX model is based upon the 30-day window into the future. Thus, the volatility index is giving you a glimpse into the implied volatility of the larger market over the next 30 days.
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What Does This Math Mean?
All these levels of math and abstraction can be tricky to navigate. The simplest but most direct understanding of the VIX is that it is based upon the volatility of S&P 500 Index options. Through the tracking of changes in prices to both calls and puts, it measures demand for all forms of options.
According to the CBOE, “The VIX Index measures 30-day expected volatility of the S&P 500 Index. The components of the VIX Index are near- and next-term put and call options with more than 23 days and less than 37 days to expiration..”
The VIX is a contrarian indicator, which means it helps you find points that are tops, bottoms, and lulls in the larger market. As the financial markets have continued to mature and institutional investors are making up large portions of the market, the VIX can be useful for understanding the sentiments of these largest actors.
How to Use the VIX
Some argue that when the VIX is high, it is time to buy. Others argue that when the VIX is high you should sell to avoid the volatility ahead, and buy when it is low. Clear as mud.
This contradiction means you should use the VIX to inform your particular strategy. If, for example, you are more comfortable with periods of high volatility, you may well buy when the VIX is high knowing that you’re in for a bumpy ride. On March 18, 2020, the VIX closed at an all-time high of 89.53 as the market was in a tailspin. Some investors bought in at this point and many of them ended up making a great deal of money. The VIX can spike during major downturns, which can be a great time to buy into the market if you have the stomach for it.
The VIX is a generalized index that gauges the sentiment of the market, not a technical indicator that tells you exactly when to move into or out of a particular stock. Some investment strategies would have you buy in during periods of high volatility, while others may suggest investing in safe havens until the VIX goes low. Further, the VIX should only be used along with other indicators to determine the state of the market. It is best used as a secondary indicator, often along with the follow-through day, which is the instance where a major index closes significantly higher than the previous day and in greater volume.
The spread of the VIX as a percentage can be tricky to interpret. As a general rule, the VIX will never reach 0 — a mathematical impossibility — and it will probably never be 100.
Historically, there are twilight points that are informative. When the VIX drops below 20, this represents a point of extreme complacency in the market. When VIX goes above 80, this means that the situation is volatile — historically, it often means that a crisis is underway or imminent.
A VIX spike of more than 20% of the 10-day moving average can confirm a reversal in the stock market, whether going up or down.
As an index that is built of indirect data, you cannot directly buy shares of the VIX. Instead, you can buy VIX exchange-traded funds (ETFs), which hope to model the VIX. Historically, these funds have performed poorly. The closest ETF model to the VIX is the ProShares Short VIX Short-Term Futures ETF (NYSEARCA: SVXY). Given the nature of the VIX, and as a result all ETFs based thereon, long-term value for these financial instruments is debatable.
Exchange Traded Notes (ETNs) make up the bulk of derivative options available for interacting with the VIX. There are a number of choices in the ETN realm for investing in VIX, notably the Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN (BATS: VXX) and the Barclays Bank iPath S&P 500 Dynamic VIX ETN (BATS: XVZ). These investment strategies better handle the market’s expectations over the medium term than any ETF has to date, so it will instead handle the market through long term volatility.
Other Volatility Indexes
The VIX is far from the only volatility index out there; it is merely among the most popular given its approximate modeling of the larger market. For those who are trading in smaller niches, more appropriate and targeted indexes may provide a better tool.
For example, the CBOE NASDAQ 100 Volatility Index (VXN) is a composite index based on the Nasdaq 100 — the highest valued and most traded stocks on the Nasdaq composite index — that tracks its implied volatility. During some periods of turmoil for the larger markets, the Nasdaq 100 may be relatively sheltered from the larger concerns. The VXN was first created as a response to the 2001 dot-com crash where the larger equity markets were relatively unphased despite technology companies plummeting in value.
Other indexes represent other specialized subsets of the market, giving you an insight into a specific niche of the market.
Like all indexes, the VIX gives you an insight into the market. It should not be over-relied upon in making your decisions. If you are investing in international markets, the VIX can be unreliable. Further, there is no hard-and-fast rule for trading based upon the index. It is a measure of the sentiment of the market, but even then it can be insufficient to determine the details of what will happen next.
If you are handling your own investments, watching VIX closely will be helpful to maximize your return on investment. If, however, you are more hands-off with your investment, it may make sense to check in only occasionally if you are considering putting an extra windfall or other larger than normal investment into the market.