VIX volatility index “fear index” for options traders and investors

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VIX volatility index “fear index”. How to use it in options trading?

Definition of the VIX Index

The volatility index with the VIX ticker or, as traders call it, the fear index. This index belongs to a group of indices that measure market volatility. Calculation of this index is carried out by CBOE – Chicago Options Exchange. The basis for calculating this is the change in the prices of CBOE options. Naturally, we are talking about call and put options. The exchange calculates this index in real time. This index shows how the annual value of the S&P 500 index volatility options will change over a 30-day period. VIX index is measured in percentage points. The confidence level of this index is 68%.

What is the role of the VIX Index for option traders?

If we take a closer look at the output of this index, we will see that it takes the market prices of options whose expiration expires more than 23 days and less than 37 days. Also, risk-free U.S. Treasury bonds and interest rates on bills are accepted. The very value of the VIX index for traders of binary options and other types of options is that they can get relatively accurate data for a short period of time. Having carefully studied the data, you can find out how you need to act. In other words, after 30 days, you can find out how to change the annual volatility of the S&P 500 index with an accuracy of 68%. Very cool thing! To simplify, this index reduces the risk of losing your assets when trading options when used properly. Below are examples:

– With an increase in the number of investors who fear a fall in markets, premiums on put options increase, while on call options decrease.

– If investors are confident in the growth of markets, premiums on call options will increase, and on put options will decrease.

– If there is no confidence in market participants in the market participants, then investors will look towards insurance and reducing the risks of losing their assets. In this case, the call and put premiums of the options will rise.

В This index can be used in two directions. With his data, your hedge can be even more effective. Or you can make a number of successful transactions that will bring you profit. Reflecting the expectations of investors with this index can also serve as a good signal for you to buy assets for the long term.

How to apply VIX Index to traders in analyzing market conditions

There are many ways to use the VIX Index for traders. Both trading strategies and entire trading systems are based on this index. The VIX index has a scale for measuring the “fear” of investors from 0 to 100. Most often, the VIX index values ​​range from 15 to 40. For example, take an average value of 30 points. Consider 2 cases and what they will reflect by themselves. If the value of the VIX index is below 30 (20), then it is generally accepted that investor concerns are at a fairly low level. If the value of the fear index fluctuates in a narrow range (15-20), then we can clearly see the prerequisites for a growing trend in the medium or long term. If the index is greater than 30, this indicates an increase in investor concerns. Naturally, in order to protect themselves from price fluctuations, they will buy in smaller volumes, or completely refuse to buy options with a further increase in the index. This is typical behavior for insuring your assets against price fluctuations and a possible market fall. It should be understood that the index cannot be considered as an indicator of market entry into a downtrend. Everyone knows about the period from October 2008 to March 2009, when the index showed over-growth, and US indices continued to fall.

Conclusion

The VIX index is still an excellent tool for analyzing market conditions. It makes a good understanding of the level of correlation of what traders are willing to trade: at the risk or premium. In order to get accurate data using this index, see its value when it fluctuates in a relatively narrow range. Using this index, you can better understand the behaviour of traders in the market, as well as see what manifestations the actions of the latter lead to.

“General Risk Warning: Binary options and cryptocurrency trading carry a high level of risk and can result in the loss of all your funds.”

CBOE Volatility Index (VIX) Definition

What Is the CBOE Volatility Index (VIX)?

Created by the Chicago Board Options Exchange (CBOE), the Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments. It is also known by other names like “Fear Gauge” or “Fear Index.” Investors, research analysts and portfolio managers look to VIX values as a way to measure market risk, fear and stress before they take investment decisions.

Key Takeaways

  • The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days.
  • Investors use the VIX to measure the level of risk, fear, or stress in the market when making investment decisions.
  • Traders can also trade the VIX using a variety of options and exchange-traded products, or use VIX values to price derivatives.

How Does the VIX Work?

For financial instruments like stocks, volatility is a statistical measure of the degree of variation in their trading price observed over a period of time. On 27 September 2020, shares of Texas Instruments Inc. (TXN) and Eli Lilly & Co. (LLY) closed around similar price levels of $107.29 and $106.89 per share, respectively. However, a look at their price movements over the past one month (September) indicates that TXN (Blue Graph) had much wider price swings compared to that of LLY (Orange Graph). TXN had higher volatility compared to LLY over the one-month period.

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Extending the observation period to last three months (July to September) reverses the trend: LLY had much wider range for price swings compared to that of TXN, which is completely different from the earlier observation made over one month. LLY had higher volatility than TXN during the three month period.

Volatility attempts to measure such magnitude of price movements that a financial instrument experiences over a certain period of time. The more dramatic the price swings are in that instrument, the higher the level of volatility, and vice versa.

How Volatility is Measured

Volatility can be measured using two different methods. First is based on performing statistical calculations on the historical prices over a specific time period. This process involves computing various statistical numbers, like mean (average), variance and finally the standard deviation on the historical price data sets. The resulting value of standard deviation is a measure of risk or volatility. In spreadsheet programs like MS Excel, it can be directly computed using the STDEVP() function applied on the range of stock prices. However, standard deviation method is based on lots of assumptions and may not be an accurate measure of volatility. Since it is based on past prices, the resulting figure is called “realized volatility” or “historical volatility (HV).” To predict future volatility for the next X months, a commonly followed approach is to calculate it for the past recent X months and expect that the same pattern will follow.

The second method to measure volatility involves inferring its value as implied by option prices. Options are derivative instruments whose price depends upon the probability of a particular stock’s current price moving enough to reach a particular level (called the strike price or exercise price). For example, say IBM stock is currently trading at a price of $151 per share. There is a call option on IBM with a strike price of $160 and has one month to expiry. The price of such a call option will depend upon the market perceived probability of IBM stock price moving from current level of $151 to above the strike price of $160 within the one month remaining to expiry. Since the possibility of such price moves happening within the given time frame are represented by the volatility factor, various option pricing methods (like Black Scholes model) include volatility as an integral input parameter. Since option prices are available in the open market, they can be used to derive the volatility of the underlying security (IBM stock in this case). Such volatility, as implied by or inferred from market prices, is called forward looking “implied volatility (IV).”

Though none of the methods is perfect as both have their own pros and cons as well as varying underlying assumptions, they both give similar results for volatility calculation that lie in a close range.

Extending Volatility to Market Level

In the world of investments, volatility is an indicator of how big (or small) moves a stock price, a sector-specific index, or a market-level index makes, and it represents how much risk is associated with the particular security, sector or market. The above stock-specific example of TXN and LLY can be extended to sector-level or market-level. If the same observation is applied on the price moves of a sector-specific index, say the NASDAQ Bank Index (BANK) which comprises of more than 300 banking and financial services stocks, one can assess the realized volatility of the overall banking sector. Extending it to the price observations of the broader market level index, like the S&P 500 index, will offer a peek into volatility of the larger market. Similar results can be achieved by deducing the implied volatility from the option prices of the corresponding index.

Having a standard quantitative measure for volatility makes it easy to compare the possible price moves and the risk associated with different securities, sectors and markets.

The VIX Index is the first benchmark index introduced by the CBOE to measure the market’s expectation of future volatility. Being a forward looking index, it is constructed using the implied volatilities on S&P 500 index options (SPX) and represents the market’s expectation of 30-day future volatility of the S&P 500 index which is considered the leading indicator of the broad U.S. stock market. Introduced in 1993, the VIX Index is now an established and globally recognized gauge of U.S. equity market volatility. It is calculated in real-time based on the live prices of S&P 500 index. Calculations are performed and values are relayed during 2:15 a.m. CT and 8:15 a.m. CT, and between 8:30 a.m. CT and 3:15 p.m. CT. CBOE began dissemination of the VIX Index outside of U.S. trading hours in April 2020.

Calculation of VIX Index Values

VIX index values are calculated using the CBOE-traded standard SPX options (that expire on the third Friday of each month) and using the weekly SPX options (that expire on all other Fridays). Only those SPX options are considered whose expiry period lies within 23 days and 37 days.

While the formula is mathematically complex, theoretically it works as follows. It estimates the expected volatility of the S&P 500 index by aggregating the weighted prices of multiple SPX puts and calls over a wide range of strike prices. All such qualifying options should have valid non-zero bid and ask prices that represent the market perception of which options’ strike prices will be hit by the underlying during the remaining time to expiry. For detailed calculations with example, one can refer to the section “VIX Index Calculation: Step-by-Step” of the VIX whitepaper.

Evolution of VIX

During its origin in 1993, VIX was calculated as a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options, when the derivatives market had limited activity and was in growing stages. As the derivatives markets matured, ten years later in 2003, CBOE teamed up with Goldman Sachs and updated the methodology to calculate VIX differently. It then started using a wider set of options based on the broader S&P 500 index, an expansion which allows for a more accurate view of investors’ expectations on future market volatility. The then adopted methodology continues to remain in effect, and is also used for calculating various other variants of volatility index.

Real World Example of the VIX

Volatility value, investors’ fear and the VIX index values move up when the market is falling. The reverse is true when market advances – the index values, fear and volatility decline.

A real world comparative study of the past records since 1990 reveals several instances when the overall market, represented by S&P 500 index (Orange Graph) spiked leading to the VIX values (Blue Graph) going down around the same time, and vice versa.

One should also note that VIX movement is much more than that observed in the index. For example, when S&P 500 declined around 15% between August 1, 2008 and October 1, 2008, the corresponding rise in VIX was nearly 260%.

In absolute terms, VIX values greater than 30 are generally linked to a large volatility resulting from increased uncertainty, risk and investors’ fear. VIX values below 20 generally correspond to stable, stress-free periods in the markets.

How to Trade the VIX

VIX index has paved the way for using volatility as a tradable asset, although through derivative products. CBOE launched the first VIX-based exchange-traded futures contract in March 2004, which was followed by the launch of VIX options in February 2006. Such VIX-linked instruments allow pure volatility exposure and have created a new asset class altogether. Active traders, large institutional investors and hedge fund managers use the VIX-linked securities for portfolio diversification, as historical data demonstrates a strong negative correlation of volatility to the stock market returns – that is, when stock returns go down, volatility rises and vice versa.

Other than the standard VIX index, CBOE also offers several other variants for measuring broad market volatility. Other similar indexes include the Cboe ShortTerm Volatility Index (VXSTSM) – which reflects 9-day expected volatility of the S&P 500 Index, the Cboe S&P 500 3-Month Volatility Index (VXVSM) and the Cboe S&P 500 6-Month Volatility Index (VXMTSM). Products based on other market indexes include the Nasdaq-100 Volatility Index (VXNSM), Cboe DJIA Volatility Index (VXDSM) and the Cboe Russell 2000 Volatility Index (RVXSM). Options and futures based on RVXSM are available for trading on CBOE and CFE platforms, respectively.

Like all indexes, one cannot buy the VIX directly. Instead investors can take position in VIX through futures or options contracts, or through VIX-based exchange-traded products (ETP). For example, ProShares VIX Short-Term Futures ETF (VIXY), iPath Series B S&P 500 VIX Short Term Futures ETN (VXXB) and VelocityShares Daily Long VIX Short-Term ETN (VIIX) are many such offerings which track certain VIX-variant index and take positions in linked futures contracts.

Active traders who employ their own trading strategies as well as advanced algorithms use VIX values to price the derivatives which are based on high beta stocks. Beta represents how much a particular stock price can move with respect to the move in broader market index. For instance, a stock having a beta of +1.5 indicates that it is theoretically 50% more volatile than the market. Traders making bets through options of such high beta stocks utilize the VIX volatility values in appropriate proportion to correctly price their option trades.

How to Use a VIX ETF in Your Portfolio

When it comes to investing, market volatility – that is, the combination of the speed and magnitude at which prices change day in and day out, is a critical measure to pay attention to.

The Chicago Board Options Exchange (CBOE) has created a handy financial tool to track market volatility, known simply as Volatility Index, but better known by its acronym, the VIX. The VIX index is generated from the implied volatilities extracted from prices of index options on the S&P 500, and is intended to reflect the market’s expectation of 30-day volatility.

Keeping an eye on market volatility is one thing. But investors can also benefit by trading securities that track the value of the VIX itself. Here, we consider using VIX ETFs.

Key Takeaways

  • The VIX, or the volatility index, is a standardized measure of market volatility and often used to track investor fear.
  • Investors can trade ETFs that track the VIX in order to speculate on or hedge against future market moves.
  • Understanding how the VIX and its ETFs work, including its unique risks, is key before adding it to your portfolio.

The Volatility Index

Referred to as the so-called “fear index,” the VIX is commonly used to gauge investor confidence in the market, or, conversely, as a way of understanding how fearful market participants are that volatility will plague the space. The VIX tends to be largely based on stock market reactions; for instance, when the prices of stocks fall, VIX tends to increase, often to an exaggerated degree.

VIX is an incredibly useful tool for mainstream investors looking to trade in stocks directly. However, investors can also trade based on the VIX in other ways as well. For example, the CBOE offers both VIX options and VIX futures. These allow investors to make wagers based on the volatility index itself, rather than on the changes to individual names it attempts to represent. Because of the large-scale reactions common to the Volatility Index, traders and investors are often interested in trading based on VIX.

It is perhaps unsurprising that there is also a growing field of VIX-linked exchange-traded funds (ETFs). These products are a bit more complex than standard ETFs that track a basket of stocks. However, there are nonetheless compelling reasons to consider VIX ETFs. In doing so, though, investors should pay careful attention to how VIX ETFs work and learn about the potential risks and rewards associated with this subcategory of the ETF space.

What to Watch Out for When Using ETFs in a Portfolio

What is a VIX ETF?

VIX ETFs are a bit of a misnomer. Investors are not able to access the VIX index directly. Rather, VIX ETFs most commonly track VIX futures indexes. This characteristic of VIX ETFs introduces a number of risks that investors should keep in mind, and that will be detailed below. It also introduces the opportunity for a variety of different types of products within the VIX ETF category. Furthermore, most VIX ETFs are, in fact, exchange-traded notes (ETNs), which carry the counterparty risk of issuing banks. This is not typically a major concern for VIX ETF investors.

One of the most popular VIX ETFs is the iPath S&P 500 VIX Short-Term Futures ETN (VXX). This product maintains a long position in first- and second-month VIX futures contracts, which roll daily. VXX tends to trade higher than it would otherwise during periods of low present volatility as a result of the tendency for volatility to revert to the mean.

Inverse VIX ETFs are those that profit from the opposite movement of the VIX. When volatility is high, stock market performance usually goes down; an investment in an inverse volatility ETF can help to protect a portfolio during these highly turbulent times. On the other hand, when the VIX climbed by a massive 115% early in 2020, many products that short futures connected to the VIX were decimated. Indeed, both the VelocityShares Daily Inverse VIX Short-Term ETN and the VelocityShares VIX Short Volatility Hedge ETN shut down in part as a result of this movement.

One example of a popular inverse VIX ETF is the ProShares Short VIX Short-Term Futures ETF (SVXY). Based on VIX short-term futures as an index benchmark, this ETF provides an 0.5x inverse exposure to the underlying index, meaning that it is not a leveraged ETF. For 2020, SVXY returned a whopping 181.84%. However, just as volatility itself can be highly volatile, so too can VIX ETFs; in 2020 through mid-July, the SVXY product had returned -90.08%.

Other inverse ETFs make use of S&P 500 VIX Mid-Term Futures as an index. Products like the VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV) managed to bring in returns of more than 90% in 2020 thanks to this strategy.

VIX ETF Risks

One issue inherent in VIX ETFs is that the VIX itself is more accurately described as a measure of “implied” volatility, rather than volatility directly. Because it is a weighted mixture of the prices for different S&P 500 index options, VIX measures how much investors are willing to pay to be able to buy or sell the S&P 500.

Beyond this, VIX ETFs are known for not being great at mirroring the VIX. One-month ETN proxies captured only about 25% to 50% of daily VIX moves, and mid-term products tend to perform even worse in this respect. The reason for this is that VIX futures indexes (the benchmarks for VIX ETFs) tend to be unsuccessful at emulating the VIX index.

In addition, VIX ETF positions tend to decay over time as a result of the behavior of the VIX futures curve. As this decay takes place, these ETFs have less money to use to roll into subsequent futures contracts as existing ones expire. As time goes on, this process repeats itself multiple times, and most VIX ETFs end up losing money over the long term.

As the examples above illustrate, VIX ETFs are incredibly finicky. Inverse volatility ETFs experience massive losses when volatility levels in the market spike. This can be so dramatic that these ETFs can be virtually annihilated due to a single bad day or period of high volatility. For this reason, inverse volatility ETFs are not an investment for the faint-hearted, nor are they an appropriate investment for those without a strong knowledge of how volatility works. Interested investors should carefully consider the personnel managing any inverse volatility product before making an investment. It’s also likely a good choice to see investments in inverse VIX ETFs as an opportunity for short-term gains, rather than for long-term buy-and-hold strategies. The volatility of these ETFs is too extreme to make them a suitable long-term investment option.

The Bottom Line

Investors interested in the VIX ETF space should consider investing for a short period of perhaps a day. Many of these products are highly liquid, offering excellent opportunities for speculation. VIX ETFs are highly risky, but when traded carefully, they can prove to be lucrative.

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