Volatility Index (VIX)

QUOTE AND NEWS
SeekingAlpha  Oct 17  Comment 
By Matthew D. McCall: The illusive 10 percent pullback in the market is finally here, well almost. The S&P 500 hit an intraday high of 2019 on September 9, before falling to an intraday low of 1820 on October 15. The pullback equals 9.9 percent,...
Jutia Group  Oct 17  Comment 
Over the past few months, I warned my readers the stock market had become a risky place to be. While I also suggested euphoria could bring the market higher than most thought possible—to the point of irrationality—the bubble has now burst. Key...
Yahoo  Oct 16  Comment 
Wall Street's fear gauge hit its highest level in more than two years this week. Does that spell trouble for equities?
Benzinga  Oct 16  Comment 
The return of market volatility in October has once again reminded investors that risk and fear are part of the journey when investing in stocks. The SPDR S&P 500 ETF (NYSE: SPY ) has dropped more than 5 percent this month and is down over 7...
SeekingAlpha  Oct 16  Comment 
By Josh Arnold: We have seen some very interesting and unnerving action in the stock market in the past month or so. Many fears of traders and investors have sent indices lower including Ebola, the economy, Fed rate hikes and valuations. Just...
Market Intelligence Center  Oct 16  Comment 
A covered call identified by MarketIntelligececenter.com's patented algorithm on Ipath VIX Mid-Term Futures ETN (VXZ) could yield about 8.53% (20.08% annualized, for comparison purposes only) in 155 days. Pair a long position in the ETF with a...
Clusterstock  Oct 16  Comment 
Europe's "fear index," the VSTOXX index, is going through the roof Thursday morning. The index measures volatility in European markets. It's the "cousin" of the VIX. It's at a two-year high already and still climbing. It's up 23.72% Thursday,...




 
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The volatility index ("VIX") is an index which measures expectations of volatility, or fluctuations in price, of the S&P 500 index. Higher values for the volatility index indicate that investors expect the value of the S&P 500 to fluctuate wildly - up, down, or both - in the next 30 days.

The index, commonly known by its ticker VIX, is also known as the "fear index" because a high VIX represents uncertainty about future prices. The index is calculated using the price of near-term options on S&P 500 index.[1] Because the value of an option is closely linked to the expected volatility of its underlying security, options prices can be a useful indicator of investors' expectations of volatility.

The VIX hit its historic high of 89.53 on October 24, 2008 on concerns about the 2008 Financial Crisis. Prior to this crisis, the VIX had peaked at 38 on August 8, 2002.

There is no security that realizes the VIX's "return" (like ETFs for regular indices). However, VIX-based futures contracts and options exist for professional investors. In January 2009, iPath launched two securities (VXX and VXZ) that track VIX futures rather than the VIX itself. These securities allow retail investors to speculate on the VIX.[2]

There are other volatility indexes which track expected volatility on other indices: VXD is used as an indicator of expected volatility of the Dow Jones Industrial Average and VXN is used for the NASDAQ 100 index.

What is volatility?

Volatility is the rate at which the price of a certain [security] moves. A security with high volatility has bigger fluctuations in price compared to a security with low volatility. The more quickly a price changes up and down, the more volatile it is. As such, volatility is often used as a measure of risk.

For example: A stock whose price went up 20% yesterday and went down 25% today is more volatile than a stock which increased 2% in both days.

Volatility can be observed by looking at past changes in stock price. The standard deviation of percentage changes in price is used to calculate observed volatility.

Volatility vs. Implied Volatility

Volatility is different from implied volatility, in the sense that volatility is observed by looking at past data, whereas implied volatility represents expectations about future fluctuations.

Volatility expectations, or implied volatility, is deduced from option prices (both call and put) on the underlying security -- since these expectations are reflected in market prices of the option. Higher fluctuation expectations mean that the option has a greater probability of ending in the money, and thus the option commands a higher price and vice versa. By inputting the option price, along with other variables such as maturity, interest rate, strike price and underlying security price, in a pricing model (e.g. Black-Scholes) it is possible to derive an estimate of the investor's expectation of future volatility.

The VIX is calculated by taking into account implied volatility on near-term S&P 500 options with different strike prices. Hence, it represents investor's expectations on how drastically the index may fluctuate in the near future.

Interpreting the VIX

"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." -- Warren Buffett [3]

The VIX is often referred to as the "Fear Index".[4] Although a high VIX does not represent a definite bearish signal on stock, the market fluctuates most during times of uncertainty. Historically, the VIX has hit its highest points during times of market turmoil and financial downturn.

VIX as a leading Indicator

According to research by CXO Advisory Group,[5] between 1990 and 2005, an extremely high VIX has been followed by periods of high returns on the S&P 500 index, in both short-term (1 month) and medium-term (1 year). The research defined high VIX as being 77% above its 63-day moving average. For example: When the VIX was 135% above its 63-day moving average, the S&P 500 returned 14 percent over the next year.

References

  1. CBOE paper on VIX, retrieved August 20, 2009
  2. Seeking Alpha, Retrieved April 23, 2009
  3. Annual letter to shareholder's of Berkshire Hathaway (2005), Retrieved 10/14/2008
  4. Motley Fool, 4/3/2007, Retrieved 10/14/2008
  5. CXO Advisory Group, Retrieved 10/14/2008
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