Anyone who follows the market is very familiar with the term ‘volatility’. We watch the market go up and down and the more intense the move the more volatile we say the market is. In recent years the VIX, or volatility index, has become more and more of a central part of a market enthusiast watch lists. So what exactly does the VIX measure? At its core, the VIX measures the volatility of the S&P 500. A more advanced definition is that the VIX tracks the implied volatility of a basket of options on the S&P 500. For many, you may own stock in various industries and sectors that are not necessarily in the S&P 500 but by following the VIX you can get a good idea of how volatile the market is on average. The mean or average level of the VIX is around 20. From our experience, the market will be fairly calm with the VIX below 16 and really start to whip around when it gets around 25 to 30.
One frequently asked question is “You can trade the VIX? I thought that it was not a tradable product?” This is both right and wrong. You cannot trade the VIX index itself, but you can trade VIX futures and options contracts on those futures.
Just as there are many ways to interpret a great painting, there are many ways to interpret the VIX and back out useful information. It can be viewed as how much volatility there is in the market, how much it costs to hedge a portfolio, or in a very simplified manor as the ‘fear index’. At Blackpier we view the VIX as another way to gauge what other investors are thinking. I’ll illustrate with an example. Say the S&P 500 is trading at 2,000 and the VIX is at 16. The next day the market gaps down to 1,980 and the VIX climbs up to 20, a 25% move. The following day the S&P goes right back to 2,000 and one would expect the VIX to move back to 16 but it doesn’t. Instead it only falls back down to 18. In this case, we would see that there is still uncertainty in the market and that traders believe that there is now more risk in the market than there was previously even though the S&P is at the same level.
There can be many in depth discussions on the VIX, VIX options pricing, other products based on the VIX, and the correct way to view the VIX. We hope this short article has given you a good introduction to what the VIX is and some of the ways in which to interpret the index. If you have any questions or would like to discuss the topic further, please to not hesitate to reach out to us.
Good Luck Trading!