The Fear Gauge – What is the VIX?

By , CEO of Volcube.

What is the VIX?

The VIX is a number. It is calculated and published, in real-time, by the Chicago Board Options Exchange. The VIX aims to give an indication of the 30 day implied volatility of S&P500 options.

Every option has an implied volatility which reflects several factors, the chief of which is the expected volatility in the option’s underlying product, over the life of the option. For instance, suppose a call option has an implied volatility of 20%. This can be interpreted as implying that the market expects the underlying product for this call option will have an annualised volatility of around 20%. This is useful information. If the underlying market has been observed to typically move with a volatility of around 10%, it suggests that something is up. Something has caused option traders in this market to value options more greatly than historical volatility in the underlying would suggest is justified. In other words, the increase in implied volatility indicates that current expectations are for the underlying market to become more volatile.

The VIX provides a useful global benchmark in this regard. The S&P500 index is a global benchmark for developed world equity prices. The VIX averages and time-weights several options on this index to give a consistent measure of 30 day implied volatility. The result is a volatility index which is comparable across time and is centred on a benchmark measure of equity prices.

It is known as the Fear Gauge or the Fear Index because it has a tendency to rise markedly at times at panic in the market.

How is the VIX used?

The VIX is used as a general guide to expected volatility in the market. It could be interpreted as a forecast of actual volatility, although there is currently minimal evidence for its predictive power. The VIX is an annualised measure of 30 day implied volatility. This can cause some confusion since the time-frames seem to be convoluted. However the idea is simple to explain. Implied volatility is always shown as an annualised number i.e. a percentage that the underlying product might be expected to move over 12 months. This makes comparing options with different expiration dates a simpler affair. To convert the annualised implied vol number into the number relevant for the option’s duration, we simply divide by the square root of time. So to convert an annual volatility of 20% to a one-month volatility, we divide 20 by the square root of 12 (since there are 12 months in a year) = 5.77%. A VIX of 20% therefore suggests the stock index is expected to move, roughly, around 5.8%. By considering annualised numbers, it becomes easy to compare the implied volatility of say a 1 month option and a 3 month option. If implied volatilities were given as numbers relative to the option’s lifespan, then comparison at a glance would not be easy.

The VIX can be used as a general guide to sentiment or it can be used more formally in trading strategies. Some traders will use different values of the VIX as trigger points to enter or exit option trades.

How can the VIX be traded?

The VIX cannot be traded directly because it is simply a number. However there are several proxies that traders use. Each has strengths and weaknesses and must be understood before any trading strategy is executed.

VIX futures : These are cash settled. Strengths include liquidity but one weakness is that the futures relate to theĀ future value of the VIX, rather than its current value.

VIX options : Similar strengths and weaknesses to futures. Good flexibility, but some sense of these being derivatives on a derivative on a derivative…etc

VIX-based ETFs: Attractive in principle, given these are available to retail investors. However, they suffer from several issues in that they are usually backed by a proxy in turn. For instance, a volatility ETF might use volatility futures, such as VIX futures, as their ‘underlying’ holding. Remember that this is therefore twice removed from the index. And these futires will need rolling (often monthly) as the futures approach expiration; this can create significant expense which means the price of the ETF may, over time, diverge (adversely) from the level of the volatility index it is supposed to track.

S&P500, Emini S&P or other index options : Often the simplest solution. Trading the options from which the index is constituted makes a lot of sense. A weakness is that it is still not really practical to replicate the exact index perfectly. However the strengths from this solution make it the preferred route for many traders.

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