Known as the "fear gauge," the Volatility Index (VIX) was created by the Chicago Board Options Exchange (CBOE) in 1993. The VIX is a real-time index that measures the expected volatility of S&P 500 index (SPX) options and serves as an indicator of market uncertainty and fear. Although the VIX measures the volatility of SPX options only, it is considered a reference for the overall volatility of global markets.
How is the VIX Calculated?
One method to measure fear among market participants is by measuring volatility. Volatility can generally be calculated in two different ways. The first is historical volatility, which is based on previous prices. Historical volatility is calculated by considering various statistical data such as the average, variance, and standard deviation of past prices.
The second method used to calculate the VIX is implied volatility. This method considers the prices of options. In calculating the VIX index, SPX options with near-term expiration dates are used as prices. SPX options are contracts that give the right to buy or sell SPX at a specific price but do not obligate it.
Since the VIX is calculated using live prices of SPX options, it is a real-time indicator. Options used in the calculation include SPX options expiring on the third Friday of every month and weekly SPX options that expire every Friday. For an option to be included in the VIX index calculation, it must have a remaining maturity of 23 to 37 days.
The calculation of the VIX is a complex mathematical process. However, the basic logic involves combining weighted price data of options across a wide range of strike prices to form a forecast about the prices at which investors are willing to buy and sell SPX. This allows for an estimation of SPX's future volatility.
What Does the VIX Value Indicate?
The VIX index measures not the price of the asset but the volatility of the asset's price. The VIX does not comment on the asset's price; it only describes how much and how often the market moves. Therefore, the VIX value is expressed as a percentage point. The higher the volatility in the market, the higher the VIX value.
Typically, there is a strong inverse correlation between the VIX value and SPX returns. An increase in the VIX indicates higher risk and an expectation for SPX prices to decrease. An increase in market risk leads investors to flee to lower-risk assets.
Conversely, a decrease in the VIX can be accompanied by an uptrend in SPX. A decrease in market risk increases investors' risk appetite, making them more willing to purchase riskier assets.
The VIX uses a scale between 0 and 100. If the VIX is in the 0-20 range, it indicates low volatility and is interpreted as a high-risk appetite. Values between 20-30 indicate moderate volatility but not excessive risk. If the index reaches a value of 30 or above, it signifies extreme volatility and increased risk.
Conclusion
Although the VIX index provides investors with a forecast of market volatility and risk perception, forming a definitive judgment based solely on the index can be misleading. Evaluating the VIX index in conjunction with other indicators will lead to more informed decisions.