If the VIX is high, it’s time to buy. When the VIX is low, look out below!
DEFINITION:
The CBOE Volatility Index (VIX) is a real-time index, an indicator that estimates the degree of volatility the stock market may be in the near term and could gauge the fear among market participants.
Understanding the CBOE Volatility Index or simply “the VIX.”
The VIX helps gauge the volatility of the stock market. It is often called the fear index as it depicts the level of either fear or optimism in the market. Once people are too optimistic or fearful, there would always be a chance that the market would behave chaotically. The Chicago Board Options Exchange (CBOE) calculating the VIX Index. So, when the VIX gets higher, there’s more fear. The option prices from the S&P 500 are used to calculate the Index. In its turn, a stock option is an agreement that provides an owner with the right to buy or sell some stocks but does not oblige him to do so. It’s important to note that there is the CBOE EFA ETF Volatility Index for the international stocks.
If the weather concerns you, you could always check the forecast and decide the best time to go on vacation. The same principle works with the VIX. So if you’re concerned about the time for the investments, you could check the VIX and explore how other investors consider the nearest future of the stock market.
What is the CBOE Volatility Index (VIX)?
Let’s have a look more deeply into the Index. The Chicago Board Options Exchange made the CBOE Volatility Index to estimate volatility over the next 30 days. It measures market risk and expresses a general feeling of investors towards the market.
As it’s been mentioned above, the prices of the S&P 500 index options provide the groundings for the VIX: where buyers and sellers determine option prices. The current price of an option contract is called the option premium. And in case they’re more buyers, the option premium goes up. But if there were more sellers, the option premium would go down respectively.
The calculation of the VIX is made in a manner where the average of those prices is counted, giving a sense of what investors are ready to sacrifice for their opportunity to buy or to sell the S&P 500 index. Thus, the VIX provides a holistic picture of whether there is optimism or fear in the stock market. Generally speaking, if the VIX goes above 30, the market is considered to be volatile. And when the Index goes below 20, investors see the market as stable and calm.
How does the Index work?
The VIX goes up when more investors are purchasing the put options. And it falls when more investors are buying the call options on the S&P 500 index. Put and call options are to give the buyer the right, but not the obligation, to sell and purchase stocks at certain prices during a certain period of time. And more market volatility leads to the higher option prices. The volatility reflects the fear in the market.
What does the VIX actually measure?
The VIX rises when investors buy put options on the S&P 500, and it goes down when more call options are in higher demand. Thus, the VIX is used by investors as an indicator of instability in the market. And the Index provides a forecast of the future market volatility in the S&P 500. Also, it gives an understanding of how much people are willing to pay for the call or put options.
However, the VIX doesn’t measure the precise volatility but the market’s expectations of the volatility. Once there is more risk, more people are about to buy options. As investors often see the option prices as the degree of the risk in the market.
The VIX calculation formula
Option prices are part of the VIX calculation, but the CBOE does not use an option pricing model. Instead, CBOE uses a formula that looks at the variance of options prices with the same expiration date. To calculate the VIX, CBOE selects options for the Index. It includes a series of call and put strikes on two successive expiration dates. Then the CBOE will calculate each option’s influence on the total variance.
CBOE will then calculate the total variance for the first and second expiration dates. They then calculate the 30-day variance by interpolating the two variances. The standard deviation is the square root of the 30-day variance. Finally, the CBOE multiplies that standard deviation by 100 to get the VIX.
The importance of the VIX
The VIX is important for both traders and investors:
For the investors – it could guide them with predicting the market movements; the VIX is rising when the market goes down and decreases once the market is up.
For the traders – the higher the VIX Index means the higher option prices.
Is there a “normal’ VIX value?
The simple answer is no; there’s no “normal” value of the VIX. However, there are some numbers that investors or traders can consider. A calm marker would have the VIX level below 20. The volatile number would increase the VIX above 30. Of course, such numbers are just preliminary and subject to change. The VIX isn’t a perfect tool for the market assessment, and it appears to be only one mechanism of forecasting and a tool for the investors to stay aware of the volatility. One could never predict the stock market trends precisely, and all of the prediction tolls carry a risk, so the investments do.