The Cboe Global Markets Volatility Index, known as the VIX for short, is a tool used to measure implied volatility in the market. In simple terms, the VIX index tells investors how professional investors feel about the market at any given time.
This can be helpful for gauging and assessing risk in order to capitalize on anticipated market movements. Depending on which way the VIX is trending, it may throw off buy or sell signals to investors.
The volatility index is sometimes referred to as the “fear index” or “fear gauge” because traders rely on it as an indicator of the fearfulness of sentiment surrounding the market. While not a crystal ball, understanding the VIX and how it works can provide a useful predictor of investor behavior.
What is the VIX Index?
The VIX Index is a real-time calculation designed to measure expected volatility in the U.S. stock market. One of the most recognized barometers of fluctuations in financial markets, the VIX measures how much volatility investing experts expect to see in the market over the next 30 days. This measurement reflects real-time quotes of S&P 500 Index (SPX) call option and put option prices.
Stock volatility represents the up and down price movements of various financial instruments that occur over a set period of time. The larger and more frequent price swings, the higher volatility. Implied volatility reflects market sentiment and which way it expects a security or financial instrument’s price to move.
How Does the VIX Work?
The VIX Index is a forward-looking trend indicator used to quantify expectations for future volatility. Cboe designed the index to estimate expected volatility by aggregating weighted prices of S&P 500 Index puts and calls over a wide range of strike prices.
In options trading, the strike price represents the price at which a trader can exercise an option. Call options give an investor the right to buy shares of an underlying security; put options give them the right to sell shares of an underlying security.
The Cboe Options Exchange (Cboe Options) calculates the VIX Index using standard SPX options and weekly SPX options listed on the exchange. Standard SPX options expire on the third Friday of every month. Weekly SPX options expire on all other Fridays. VIX index calculations include:
• SPX options with Friday expirations
• SPX options with more than 23 days and less than 37 days to their Friday expiration
The index weights these options to establish a constant-maturity, 30-day measure of the amount of volatility the S&P 500 Index is likely to produce. The VIX index works differently from the Black Scholes model, which estimates theoretical value for derivatives and other financial instruments based on a number of factors, including volatility, time, and the price of underlying assets.
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The VIX is one of seven inputs used by CNN to determine its Fear and Greed Index.
What Does the VIX Tell You?
In securities trading, the VIX index is a measure of market sentiment. The volatility index has a negative correlation with stock market returns. If the VIX moves up that means investor fear is on the rise. The S&P 500 tends to see price drops in that scenario as investors may begin to sell off securities to hedge against expanded volatility that may be on the horizon.
On the other hand, when the VIX declines, that could signal a decline in investor fear as well. In that situation, the S&P may be experiencing lower levels of volatility and higher prices as investors buy and sell with confidence. This doesn’t necessarily mean that prices will remain high, however, as volatility is fluid and can increase or decrease sharply due to changing market conditions.
The volatility index can be read as a chart, with each day’s reading plotted out. Generally, a reading of 0 to 12 represents low volatility in the markets, while a range of 13 to 19 is normal volatility.
Once the VIX reaches 20 or above, that means you can typically expect volatility to be higher over the coming 30 days. For perspective, the VIX notched a 52-week high of 37.51 and a 52-week low of 14.1 as of November 26, 2021.
Example of VIX in Action
The beginning of 2020 saw a gradual rise in the level of concern surrounding the coronavirus and its potential to become a public health crisis. As more cases appeared in the United States, the financial markets began to react. The VIX index, which had hovered around 20 or below since January 2019, began to climb in the third week of February. By March 16, it had reached a peak of 82.69 and the Dow Jones had dropped 12.93%.
After the market crashed, the VIX began to slowly decline. By early November 2021, the volatility index was once again implying volatility on par with pre-pandemic levels, measuring 18.58 as of November 24.
How Investors Can Trade the VIX
Investors interested in trading the VIX index have a few options for doing so. Cboe offers both VIX options and VIX futures as a starting point.
VIX options are not exactly the same as traditional stock options. They trade nearly 24 hours a day, five days a week during extended trading hours. Investors can trade a call option or put option to make speculative investments based on anticipated volatility in the markets.
Cboe introduced VIX futures in 2004 to allow investors to trade a liquid volatility product using the VIX index as a guide. The difference between options and futures lies largely in the execution.
With options trading, the investor has the right but not the obligation to buy or sell a particular investment. A futures contract, on the other hand, requires the buyer to purchase shares and the seller to sell them at an agreed-upon price.
With VIX options or VIX futures, you’re making investments based on what you expect to happen in the markets based on how the volatility index is trending. Options and futures are speculative investments that carry more risk than some other types of investments. If you’re looking for another way to trade the VIX, you might look to VIX exchange-traded funds (ETFs) or volatility ETFs instead.
Exchange-traded funds hold a basket of securities but they trade on an exchange like a stock. VIX ETFs and volatility ETFs often hold futures contracts or track the movements of a volatility index.
Choosing volatility or VIX ETFs in lieu of trading VIX options or VIX futures directly doesn’t eliminate risk. But it can help you to spread the risk out over a diverse group of investments. If you’re already trading stocks and other securities through an online brokerage account, VIX or volatility ETFs may be included as an investment option.
The volatility index or VIX is a highly useful tool for measuring market sentiment. While it’s impossible to predict exactly which way the market will move, the VIX index can help with interpreting implied volatility when making investment decisions.
That’s information you can use whether you’re trading options or less risky investments such as stocks or ETFs. Once you’re ready to start trading, a great way to start is by opening an investment account on the SoFi Invest® platform. The platform does not provide options, but it does allow you to build a portfolio of stocks, exchange-traded funds, initial public offerings, and cryptocurrency.
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