The CBOE Volatility Index (also called the VIX) is an index designed to track the volatility of the United States stock market. Specifically, it aims to track the expected volatility of the S&P 500 through call and put options.
Investors monitor the VIX to see how the market may move, and some try to profit from guesses about how the VIX will change in the future. This article will cover how the VIX works and what everyday investors need to know about it.
Definition of The CBOE Volatility Index (VIX)
The VIX is an index created by Cboe Global Markets in 1993 that tracks how volatile the United States stock market is and is expected to be over the immediate future. It is widely used across the world as a measure of stock market volatility, with higher levels in the VIX indicating more volatility.
Like other indexes, which track the performance of a basket of stocks or other securities, the VIX measures volatility by tracking a basket of securities. The VIX tracks call and put options on the S&P 500 with expiration dates 30 days from the current date.
- Alternate name: The Fear Gauge, Fear Index
The formula for calculating the VIX is highly complex. In short, as demand for put options rises, the VIX will rise, as that implies investors expect more volatility going forward.
How Does the CBOE Volatility Index (VIX) Work?
The CBOE Volatility Index is used to track the expected volatility of the stock market based on changes in the price of S&P 500 options. Using a complicated formula, the VIX rises when stock market volatility is expected to increase, and drops when volatility is expected to drop.
The VIX is often used as a measure of investor confidence and fear. If investors are worried about the market, the VIX will rise. When investors are confident, it will fall. This has led to many people calling it “the Fear Gauge.”
Investors can trade derivatives based on the VIX, which can be useful for many reasons.
For example, if an investor believes the stock market will be more volatile in the future, they can buy VIX futures to buy the VIX at a higher price than its current price. Similarly, if they predict that volatility will drop, they can use derivatives to profit from that scenario as well.
Investors often use the VIX as a way to hedge their portfolios. Historically, the VIX has a negative correlation with stock market performance. This means that in general, the VIX will rise when the market falls, and fall when the market rises.
While historically, the VIX moves in the opposite direction from the stock market, there have been situations where it moves in tandem with the market, so investors can’t rely on it as a foolproof method for hedging their portfolio.
Investors who want to use the VIX as a hedge can buy call options or sell put options against the VIX. If the market drops, the VIX is likely to rise, letting the investor profit from the options, recouping some of their investment losses.
Do I Need the CBOE Volatility Index (VIX)?
The VIX is a unique index that gives investors access to investment strategies that can be hard to implement in other ways.
If you’re confident that market volatility and investor fear are going to increase, the VIX gives you a way to profit from that prediction. It can be difficult to invest in a way that will help you turn a profit from volatility without using securities and derivatives based on the VIX.
Other investors use the VIX as a measure of investor fear and an indicator of future stock performance. An upward trend in the VIX tends to indicate more investor fear, which could indicate future drops in stock prices. Even if you don’t get involved in securities and derivatives based on the VIX, you can use the index as a useful indicator for other trades.
What It Means for Individual Investors
Individual investors can use the VIX in many ways. The simplest way is as an indicator for future market movements as a whole. Because the VIX tends to track investor sentiment, you may be able to identify future rises and falls in the market as a whole based on movements in the VIX.
Some individual investors may want to invest directly in the VIX. While you can’t buy shares in the index, you can invest in VIX derivatives or even exchange traded products that track the VIX.
While derivatives trading is generally considered riskier in comparison to stocks, VIX futures tend to face a peculiar risk: contango. In contango, futures contracts based on the VIX tend to be priced higher than the current VIX or shorter-term contracts. If your goal is to invest in the VIX as a part of your portfolio, you’ll end up buying more-expensive futures contracts as the current ones in your portfolio expire.
VIX Exchange Traded Products
Individual investors who want to avoid the complexity of options and other derivatives may want to buy shares in VIX exchange-traded products when they expect the market to get volatile.
These products could be exchange-traded notes (ETNs) or ETFs that are structured as pooled investments or limited partnerships.
- The VIX is an index that measures the expected volatility of the stock market.
- The VIX measures volatility using call and put options on the S&P 500 with 30 days to expiration.
- Investors can’t invest directly in the VIX but can invest in ETFs that track it or derivatives based on it.