The Chicago Board of Options Exchange (CBOE) Volatility Index or “VIX” as it is commonly referred to, represents the expected 30-day volatility of annual movement for the S&P500 based on implied volatility calculated from a basket of out-of-the-money put and call options. While the VIX is perhaps the most well-known and covered volatility index there are a number of further indexes including, VXN (Nasdaq), XVD (Dow Jones Industrial Average), RVX (Russell 2000) and A-VIX (ASX200).
A volatility index such as the VIX is a fear gauge which measures market sentiment with high readings representing elevated levels of fear while low readings represent low levels of fear. One could be forgiven for assuming the VIX moves independently of the market’s direction as it simply measures overall expected volatility. However this is not the case, in fact the VIX typically has an inverse relationship to the index so that when the index is rising the VIX is falling and vice versa although in some cases we can observe the VIX at higher levels as the market also rises.
The logic behind this is that the market has an overall bullish bias; that is it tends to trend higher over time due to a number of factors including inflation and growing populations. Given the market is expected to trend higher over time, a rising market is viewed as less risky while a declining market is perceived as more risky hence why the VIX tends to move higher during market declines.
Market expectations in turn effect the buying and selling of options which are used for this calculation. When there is increased buying of option contracts this increases option prices and the result is higher implied volatility, while increased net selling reduces the price of options and therefore lowers the implied probability.
The calculation used by the CBOE is rather complex and not necessary for all investors to understand (for those who do further information is found here) but it is important to understand how to interpret the reading. If the VIX is trading at 30 this implies that the market expects a 30% move in either direction over the next twelve months. Typically readings over 35 are interpreted as high and therefore the market is fearful while readings below 15 are viewed as calm and potentially complacent.
Traders and investors use the VIX as a contrarian signal; that is they buy stocks when the VIX is high (panic in the market) and sell when the VIX is low (market becoming complacent). The image below highlights such an outcome, whereby a spike in the VIX corresponds with the S&P500 being heavily oversold, in this example following the June 23rd referendum where the U.K. voted to leave the European Union causing a great degree of fear in the market.
We can see that the corresponding spike in the VIX providing an excellent buying opportunity for the S&P500, that is the fear in the market led to an overreaction and excess selling which rebounded to new all-time highs over the following weeks.
To conclude the VIX is a useful fear gauge of the market, however it does not predict the return or direction of the market and should be used with further analysis to confirm signals.
