Introduction

The Cboe Volatility Index (VIX) is considered to be one of the most important tools for measuring the volatility of the equity market. VIX Index, in the U.S. market, is based on real-time prices of futures and options of the S&P 500 (SPX). It reflects investors’ consensus on the future (30-day) expected stock market volatility. Very simply, the volatility index is the ‘fear gauge’ of the market. The VIX index is a significant component in the Cboe Global Markets’ volatility franchise.

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Volatility indices are based on stock indexes, individual stocks, exchange-traded funds, commodities and several other performance-based indexes. The volatility contracts are traded as VIX futures and VIX options. These volatility products are now available for investors and are used effectively to manage risks, leverage volatility and diversify a portfolio.

What is Cboe Volatility Index?

The VIX index is a market estimate of future expected volatility that is based on real-time data collected on the exchange for the S&P 500 Index (SPX). Very specifically, the VIX index intends to provide an immediate measure of how much the market might fluctuate in the near term. We get to know what a market maker “thinks” of the S&P 500 for the next 30 days following each tick of the VIX Index. This index represents an equilibrium price for risk by evaluating the prices of SPX options. The prices of options may rise or fall based on the order flow from traders around the world.

Taking the example of US markets, the S&P 500 index is comprised of a portfolio of stocks, and the VIX index is comprised of changing portfolio in SPX options.  In fact, the VIX index changes every single minute, given the maturity of SPX options is 30 days. Practically speaking, traders cannot physically buy or hold the constituent SPX options of the VIX Index. National stock exchanges continuously rebalance the portfolio of SPX options in order to keep track.

The SPX option is used for settling the VIX derivatives. However, the exact constituents of the SPX options portfolio are not known during the lifetime of the VIX derivative, until it expires. Traders use the VIX Index formula to calculate the value of their contract, and they apply on the day of expiry. The formula is the only requirement for calculating the risk, without the need to bother about the composition of the VIX Index.

Important terminology for VIX Index

VIX futures are traded on the Cboe Futures Exchange (CFE) and VIX options are traded on the Cboe. CFE and Cboe provide a list of weekly of VIX derivatives. The settlement for standard VIX derivative is on the third Friday of each month. On the other hand, VIX derivatives are settled from calculating only the weekly S&P options and expire on all other Fridays.

  • Expiry – VIX derivative generally expire on Wednesday mornings. If the Wednesday or Friday after 30 days falls on a Cboe holiday, then VIX option will expire on the day immediately preceding that Wednesday or Friday.
  • Last Trading Day – The day immediately before expiration (usually a Tuesday) is the last trading day for VIX options and the last trading day for VIX futures is on their expiration day itself.

Why should we care?

After looking at the VIX calculation, we can clearly say that there exists a direct relationship between options and Cboe VIX. Therefore for investors who don’t regularly use options as a part of their investment strategy, the VIX may not be very relevant to them. But even then Cboe volatility index plays a significant role in the mindset and decision-making process of individual investors.

  • The Cboe VIX has an inverse relationship to the market’s movement, because of its tendency to rise when the market drops and decline when the market rises. Theoretically speaking this inverse relationship does not exist when the market just soars higher and higher or crashes towards the downside. However, history has shown that stocks have shown more dramatic moves on the downside than to the upside, and this explains the inverse relationship between the VIX and the stock market broadly.
  • Short term traders might interpret the high value of VIX as an upcoming danger zone. The long term investors use VIX to analyse individual stocks more closely and take decisions carefully.
  • Hence using VIX as an early warning system, one can start looking for great opportunities. This has been a smart strategy over time. It is being used frequently nowadays as the volatility has doubled compared to before.

Bottom Line

It is essential to understand that VIX has limited usefulness when looking at individual stocks. The VIX is broader in nature and is related to the S&P 500 index and measures the volatility of the entire U.S large-cap market.

The Cboe estimates volatility based on specific criteria for individual stocks and this criterion changes timely. The figures vary greatly when considered for constituent stocks in that index.

VIX is especially crucial for options traders as they love volatility (get the advantage of time value) but individual investors can also refer to it. Hence it is always advised to track the VIX index irrespective of the kind of trader. In this way, you can sense the mood of the overall market, and understand what options traders are making out from the market (If they are expecting good times or bad times).

That’s about VIX indicator. Watch this space for more quality education!

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