VIX - Introduction
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Why Does Volatility Matter?
One could never understand the significance of the VIX without first understanding what volatility is. Volatility is defined as "Tendency to fluctuate Sharply & Regularly" at dictionary.com. Hence the saying,"A volatile market". Volatile markets are characterized by wild swings with big up days followed by sudden sharp drops. Volatile market conditions makes it extremely hard for traders and investors to decide if it is time to take profit or cut losses as stocks could suddenly resume bullishness or collaspe. Volatility affects options trading as well. Higher volatility means higher options premiums. making it extremely disadvantageous to execute debit options strategies. Higher options premium also mean a much higher breakeven point for every debit options strategies, making it harder for them to make money. On the other hand, higher volatility also makes credit options strategies or Covered Calls extremely profitable as there are now much more extrinsic value to profit from. Without a means to measure the level of volatility in the market, options traders would not be able to make a completely educated decision on the options strategy to use for the prevailing circumstances.
This is why being able to quantify and measure volatility is so important in options trading and what makes the VIX so essential.
History Of The VIX
Calculation for the VIX was first introduced in 1993 by the Chicago Board of Exchange (CBOE) and have gone through one major change to its algorithm. In 2004, futures trading was enabled on the VIX and in 2006, VIX options was launched. These derivatives enabled traders to trade and hedge against volatility for the first ever time.
Interpreting The VIX
The VIX is quoted as a percentage estimating the implied volatility of the market, which is the expected annualized movement of the S&P-500 over the next 30 days. Not to get too technical, when the VIX is at 30, it means that the S&P-500 might move as much as 2.5% (30% divided by 12 months. There is some contention here about whether it should be divided by 12 or should it be a discounted value taking into consideration compounding. Either way, there is no need to complicate things as both methods are not known to produce an exact prediction of how much the S&P500 will move in a month. As traders, not academics, we focus on what the number suggests. Hence the more straight forward method is presented here.) up or down over the next 30 days.
When the market is trending steadily upwards, there is generally a low level of volatility in the market as complacency sets in and more call options are bought than put options. Conversely, when a market is falling, there is generally widespread panic in the market causing a high level of volatility as more put options are bought than call options. This correlation is also why the Put Call Ratio is read in conjunction with the VIX to provide more insight into the state of volatility in the market. Together, the Put Call Ratio and the VIX have been known as "investor fear gauges".
When the US stock market enters a sharp correction in January 2008, the VIX also spiked to a multi-year high of over 37. Conversely, when the US stock market was at the height of its bull run in 2006, VIX was as low as 8.6, which again was a multi-year low. The correlation between the VIX and the state of the market is uncanny. This is why the VIX is useful not only for options traders as stock traders and investors also use the VIX as a market timing devise or a contrarian indicator.
As a contrarian indicator, the higher the VIX, the more bearish the market is and conversely, the lower the VIX, the more bullish the market is.
Extreme readings in the VIX has also been used as a reversal indicator. Ever since the VIX spiked over 37 in January of 2008, the US stock market bottomed out and staged a recovery. Similarly, when the VIX bottomed at 8.6 in 2006, the US stock market slowed down in 2007 and then corrected sharply.
VIX is also a direct indication of the level of implied volatility in the options market.
The higher the VIX, the more profitable credit spreads and naked writes become due to the fact that all options contains relative higher extrinsic value than when the VIX is low. Options traders could therefore change options strategies as the market conditions change, favoring debit spreads when the VIX is low and credit spreads when the VIX is high.
The real question now is, when is the VIX high or low?
There really isn't a standard to what constitutes a high or low VIX reading. Apart from using your experience and gut feel, there are 2 main ways to read the VIX. 1, Multi-years high or low. 2, VIX trend.
Multi-year highs or lows typically warns investors that turning points may be near. The above examples marked two market reversals when the VIX was in multi-year high and low. Investors and traders may consider covering or closing profitable positions when these points are reached.
The trend of the VIX also provides an indication to the trend of the stock market. In a bull market, the VIX is typically trending downwards and in a bear market, the VIX is typically trending upwards. The VIX was trending downwards steadily in the big bull run of 2003 to 2006.
You can see the daily VIX chart from our Option Trader's HQ.
How Is The VIX Calculated?
The calculation for the VIX underwent a major change since September 2003. The original VIX (now known as VXO) was calculated by averaging the implied volatility of at the money (ATM) options of the S&P 100 (OEX) using the Black-Scholes Model. There were obviously too many flaws in the original VIX calculation as the OEX, comprising only 100 stocks, cannot be taken as the closest representation of the stock market and implied volatility derived through the Black-Scholes Model are littered with flaws inherent in the Black-Scholes Model itself.
The new VIX calculation, which results in the present VIX, estimates implied volatility by a weighted average of a wide range of strike prices in the S&P-500 using a newly developed formula which is independant of any currently known models. In fact, just by switching to using the S&P-500 instead of the S&P-100, the VIX much more correlated to actual market volatility, increasing the value of VIX futures and VIX options as hedging tools. Using a range of strike prices rather than just at the money options also acknowledges the difference in implied volatility across different strike prices (the volatility smile ).
To arrive at the VIX value, a wide range of In The Money to Out Of The Money call options and put options of two expiration months bracketing the nearest 30-day period are selected. The implied volatility of all options of each of the selected months are estimated on a price weighted average basis in order to arrive at a single average implied volatility value for each month. Finally, results of the two months are interpolated using a 30 days constant and then a percentage derived from the square root of that result.
VIX Variants - VXN & VXD
Apart from the VIX and the VXO, volatility index is also calculated for the NASDAQ 100, going by the ticker symbol VXN as well as for the Dow Jones Industrial Average, going by the ticker symbol VXD. The VXN, short for CBOE NASDAQ-100 Volatility Index, and the VXD, short for CBOE DJIA Volatility Index, use the same formula for the VIX and applies it to the NDX (NASDAQ 100 index) and DJ-30 (Dow Jones Industrial Average). They work exactly the same way as the VIX and can be interpreted in the exact same manner. Futures and Options are also available for both the VXN and VXD, allowing sector or industry specific investors and traders to hedge volatility risk directly.
VIX options began trading on the CBOE on February 24, 2006. This marked the beginning of the ability to apply options trading strategies in order to profit from implied volatility directly. Options traders could now put on a bullish options strategy such as a Bull Call Spread on the VIX if they think that volatility is going to increase. Such ability to profit directly from volatility never existed before the invention of the VIX options. VIX options differs from stock options in some way and you can learn more from our VIX Options Tutorial.