Credit: Shutterstock photoGood riddance to May, you're probably thinking. What with flash crashes, slow motion crashes, corrections, 300-point rallies, 400-point rallies -- you're probably looking for a little less volatility in your life, not to mention your portfolio. In fact, one of the most-watched measurements of market volatility has also been in the headlines this month -- the CBOE Market Volatility Index ( VIX ). Much is made of fluctuations in the VIX in various financial media outlets, but how much do you really know about this nifty little index? Read on to learn more about what the VIX is, how it's calculated, and what this all has to do with options.
The nuts and bolts of the VIX
There's a good chance that you've heard the VIX referred to as the "fear gauge." This is all well and good, and it gives you a vague idea as to what on Earth you might be looking at -- but this description is oversimplified at best.
As the name implies, the CBOE Market Volatility Index ( VIX ) was created by the good people at the Chicago Board Options Exchange ( CBOE ) . The VIX was launched in 1993 in order to track investors' expectations for short-term volatility in the stock market. For the first 10 years, the value of the VIX was derived from the implied volatilities of eight different at-the-money S&P 100 Index ( OEX ) options.
However, CBOE completely revamped the VIX in 2003. Now, the index is based on the prices of a wide variety of S&P 500 Index ( SPX ) options, and the prices are weighted to offer an outlook as to what investors are expecting from stocks during the next 30 days. Rather than concentrating exclusively on at-the-money strikes, the VIX now takes into account a broader range of strike prices -- as well as a broader range of equities, via the SPX. (You can still track expected volatility for OEX by checking out another of CBOE's volatility indexes, the VXO.) Additional information can be found by checking out the VIX White Paper .
What does all this mean for you? Here's the deal: rising implied volatility is generally associated with bearish price action. When investors are anticipating major downside in the stock market, volatility will creep higher. Conversely, when bullish price action is expected, volatility levels generally remain very tame. (Note the liberal use of the word "generally" here -- on an equity-specific basis, implied volatility can also be influenced by scheduled events, such as earnings reports.)
So, at the most fundamental level, rising expectations for bearish price action will result in higher implied volatility on SPX options, which will then translate to an increase in the VIX. This is where the delightfully basic "fear gauge" descriptor comes in. If investors are feeling more fearful of a market crash (or dip, or pullback, or correction), the VIX will theoretically rise. Conversely, expectations for bullish price action in the broad market should usually result in a dip for the VIX.
In light of this, you might expect the VIX to move directly inversely with the SPX -- but that's not the case. Remember, rather than tracking the actual price action of the market, the VIX tracks investors' expectations for the market during the next 30 days. In other words, we're only measuring changes in Wall Street's mood with this tool. Because of this, the relationship between the two indexes could more accurately be described as "vaguely inverse."
As a caveat, it's not unusual to see a big spike in the VIX on major down days for the SPX. That's because a single-day sell-off can spark increased anxiety among investors, thereby pushing implied volatility -- and short-term SPX option prices -- skyward. But on more typical trading days, with less dramatic price changes, the movements of the VIX relative to the SPX are harder to predict.
Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
