The Cboe Volatility Index, better known as VIX, projects the probable range of movement in the U.S. equity markets, above and below their current level, in the immediate future. Specifically, VIX measures the implied volatility of the S&P 500® (SPX) for the next 30 days. When implied volatility is high, the VIX level is high and the range of likely values is broad. When implied volatility is low, the VIX level is low and the range is narrow.
Since VIX reaches its highest levels when the stock market is most unsettled, the media tend to refer to VIX as a fear gauge. In the sense that VIX is a measure of sentiment—of worry in particular—the description is on the mark.
Implied volatility typically increases when markets are turbulent or the economy is faltering. In contrast, if stock prices are rising and no dramatic changes seem probable, VIX tends to fall or remain steady at the lower end of its scale. VIX, in other words, is negatively correlated with stock performance.
For example, in March 2020, as investors grappled with the COVID-19 crisis, VIX reached an all-time high of 82.69. In the winter of 2013, with stock prices high, VIX hovered around 12.
VIX and the S&P 500 typically move in opposite directions, with VIX anticipating the S&P 500’s behavior 30 days out.
VIX measures implied volatility by averaging the weighted prices of a wide range of put and call options. When investors buy and sell options, the positions they take—either puts or calls—the prices they are willing to pay, and the strike prices they choose, all reflect how much and how quickly they think the underlying index level will move. In fact, that’s what volatility is: the pace and amount of change. VIX uses options prices rather than stock prices in its calculation because options prices reflect the volatility buyers and sellers expect. That’s what implied in implied volatility means.
The options used to calculate VIX are put and call options on the S&P 500. Because the index represents approximately 80% of the total market value of U.S. equities and benefits from one of the most liquid markets in the world, using S&P 500 options ensures that VIX represents a broad—and current—view on volatility. What’s more, VIX uses a specific combination of options that is designed to balance out all the other factors that generally affect option prices, resulting in an index that parallels volatility expectations alone.
Holding an index call option gives you the right to a cash settlement if the index value is higher than the strike price of the option.
Holding an index put option gives you the right to a cash settlement if the index value is lower than the strike price of the option.
Future "implied" volatility, 30 days out
The VIX time frame is significant. VIX anticipates moves in the S&P 500 specifically over the next 30 days. That is enough time for investors to make decisions and act on them, but close enough to add a note of urgency if significant change is forecast.
Simply put, VIX measures the expectation of stock-market volatility as communicated by options prices. Rather than measuring “realized” or historical volatility, VIX projects “implied” or expected volatility–specifically 30 days in the future–by measuring changes in the prices of options on the S&P 500.
Many investors use an investment linked to the VIX to diversify their portfolios, seeking to hedge portfolio risk without significantly reducing potential return. For example, when markets are unsettled, investors may allocate a small percentage of their capital to VIX-related products, such as ETFs or ETNs linked to VIX futures, hoping to offset anticipated losses in their investment portfolios.
What makes VIX attractive in a diversification strategy is first its consistently negative correlation with equity securities: the more the market falls, the more volatility increases.
Second, VIX tends to rise more dramatically when markets fall significantly. For example, if equities, or the S&P 500, were to lose 50% of their value, VIX might be anticipated to increase several hundred percent. This characteristic of typically reacting more dramatically to a large equity loss than to a large equity gain is called convexity. Convexity means the investments associated with VIX may provide greater protection when it is needed most.
The recurring up and down pattern of the market cycle may encourage investors to sell VIX-linked products following a weak period in equity markets. In this case, they anticipate equities will begin to gain value and the prices of volatility-linked products will decline. Alternatively, when VIX is low, investors may wish to buy VIX-linked products in anticipation of a future period of weakness. These similar trading strategies aim to exploit the historical tendency of VIX to revert to its mean after a period of increasingly higher or lower levels.
Investors may also seek arbitrage opportunities that result from mispricing of VIX-linked products. For example, they may sell individual options and take an opposite position in VIX-linked products, particularly if the implied volatilities of the individual options look expensive compared to VIX. Or, they may take opposite positions in VIX options or futures with different maturities. In some cases, for example, premiums on VIX-linked options may be higher or lower than realized volatility justifies, and exploiting this discrepancy may produce a profit.
Like other indices, VIX is expressed as a level, or number. Changes in the level, up or down, are expressed as percentages. But unlike other indices, whose results indicate market performance, the VIX level communicates a different type of information: the 30-day implied volatility of the S&P 500. Implied volatility, in turn, indicates the expected range of the S&P 500, above and below its current level, over the next 30 days.
The higher the VIX level on any given day, the higher the implied volatility and the wider the range of potential variation in the level of the S&P 500. For example, if the current level were 10—which is at the low end of historical readings—the deannualized 30-day implied volatility is 2.9%. This means in 30 days the S&P 500 is expected to trade between 2.9% lower and 2.9% higher than its current level. On the other hand, if the VIX level were 30, it would imply an expected level of the S&P 500 between 8.7% lower and 8.7% higher in 30 days.
Volatility can be bought or sold. It works as a diversification tool. It can provide a positive return, although it pays no interest or dividends. But unlike most traditional asset classes, volatility is never a long-term investment.
Expected range of the S&P 500
VIX is reported as an annualized number. Since volatility is statistically defined as the square root of variance, the monthly volatility implied by VIX can be calculated by dividing its level by the square root of 12 because there are 12 months in a year.
To find the 30-day implied volatility of the S&P 500 from the VIX level involves several relatively simple steps. As an illustration, assume that the VIX level is 18, and the current value of the S&P 500 is 3,550.
By following the steps presented below, you can calculate where the market reasonably expects the S&P 500 to trade in 30 days. It’s information many investors use to make near-term trading decisions.
VIX level = 18 | S&P 500 level = 3,550
VIX, or the annualized 30-day implied volatility of the S&P 500, is calculated throughout each trading day by averaging the weighted prices of a specific group of S&P 500 call and put options. As with other S&P DJI indices, the methodology used to calculate VIX is rigorous and transparent, though it differs from other indices in that it measures volatility rather than changes in security prices.
The VIX methodology specifies that S&P 500 option contracts with more than 23 days and less than 37 days to expiration are used to calculate the index. Both standard and weekly option contracts with expirations in the 23 to 37 day range are eligible.
Once a week, the options used to calculate VIX roll to new contract maturities. For example, on the second Tuesday in October, VIX would be calculated using two sets of options—a “near-term” option expiring 24 days later and a “next-term” option expiring 31 days later. On the following day, the options that expire in 30 calendar days would become the near-term options in the calculation and SPX options that expire in 37 calendar days would become the new next-term options. In this example, the near-term options would be standard S&P 500 options with 25 days to expiration, whereas the next-term options would be weekly options with 32 days to expiration.
As each VIX calculation begins, the first step is determining which option contracts, with strike prices higher and lower than the current SPX level, will be included. The number of contracts may vary from calculation to calculation, but typically includes more than 100 puts and calls. To make the cut, the contracts must have current non-zero bid and ask prices, or what is known as a quote, from investors willing to buy or sell at that price. The further a strike price is from the current SPX level, the less likelihood there is of finding a quote, and contracts without quotes are excluded. At the point that two contracts with consecutive strike prices do not have quotes, no additional contracts are eligible for inclusion and the components are set.
In the next step, the options contracts that have been selected are weighted to ensure that each has the required impact on the calculation. The VIX formula is designed to combine options in a way that means that subsequent movements in the VIX are dependent only on the volatility of the underlying. Changes in the S&P 500 level, dividends, interest rates, or other factors have no impact because they have been balanced out and removed. The precise justification for the weighting is technical, but it results in a system that weights each option in inverse proportion to the square of the option strike price. Accordingly, VIX is more sensitive to changes in the prices of options with lower strikes and less sensitive to options with higher strikes.
The VIX Network is an association of exchanges and index providers dedicated to establishing standards that help investors understand, measure, and manage volatility. The network’s members have obtained, from Cboe and S&P DJI, the rights to use the VIX methodology to calculate their own volatility indices.