Usually, when thinking about indices, the first thing that often comes to mind is the DAX, Dow Jones or NASDAQ 100. However, the Volatility Index is quite different.
The term ‘volatility’ can be explained as a statistical measure that indicates the pricing behaviour of the security or market index and helps to estimate the fluctuations that may occur in a short period of time. In simpler terms: volatility measures how moody the market is or will be in the near future.
What is VIX?
In 1992, the CBOE asked Robert Whaley, a professor of management and director of the Financial Markets Research Center at Vanderbilt University, to create a formula that would calculate implied stock market volatility based on prices from the S&P Index options.
A year later, Whaley computed daily VIX levels dating back to January 1986, based on his algorithms and the CBOE's historical record of index option prices.
The VIX is a popular real-time market index, quoted in percentage points, which represents the stock market's expectation of 30-day forward-looking volatility implied by S&P 500 Index options. Easier explained, the VIX is all about "implied" volatility: it measures how much traders and investors are ready to pay to sell or buy the S&P 500. The index is a registered trademark of CBOE.
The VIX serves as a contrarian mood indicator, helping to determine whether there is too much fear or confidence in the market. Typically, at the point when the sentiment reaches one extreme or the other, the market is inclined to reverse.
In times of political uncertainty and economic crises, the VIX tends to surge. This fact has given the CBOE Volatility Index its bynames like the “fear gauge” or the "fear index", as it is viewed by many as a market anxiety and fears measurement.
Investors and traders, as well as portfolio managers and research analysts, suggest taking into consideration VIX values to determine market risk, fear and stress when taking investment decisions.
Despite the fact that the VIX might or might not be a thorough protection from risk, traders still prefer to check this indicator from time to time to measure the direction of the attitudes towards the market and the possible path of short-term trading. As a financial indicator in its own right, the CBOE Volatility Index can be used as a means towards gains or the protection of portfolios.
How does the VIX work?
Traders and investors tend to buy options in order to protect themselves from the downside risk when anticipating a possible market fall. As they purchase these, the implied volatility rises, and that, in turn, raises the value of the VIX – and vice versa.
Traders who are looking for ways to incorporate the VIX into their portfolios have a number of alternatives to choose from. For example: