If you have been involved in the financial market for any length of time, there is a good chance that you are familiar with the VIX index, which is also referred to as the fear gauge. The VIX index has been known to keep investors on the edge of their seats for some time now.
What precisely is it, and how does it shed light on the situation? First, let’s take a quick look at what the VIX index is, and then we’ll go over some of the reasons why you should use it. Further information can be found by reading further down below.
What is the VIX Index?
To begin with, the actual name is the CBOE Volatility Index, which stands for the Chicago Board Options Exchange Volatility Index, which is quite a mouthful, which is exactly why it is commonly referred to as the VIX.
Let’s begin with a straightforward explanation of the VIX. The VIX is essentially a fear measure; it provides a snapshot of the market’s attitude at any given time. It essentially provides insight into whether investors are fearful, worried, panicked, or whatever they are feeling at that moment.
For instance, if an investor believes the market will decline, he will want to protect his investment in every manner feasible. So, let’s say he decides to switch to an investment in options, which helps mitigate the risk if the market does decline.
If a sufficient number of investors have the same opinion and decide to invest in options, option prices will rise. Hence, customers must spend extra to enroll in protection options. Therefore, the VIX will spike when a large number of investors are switching investments and feeling anxious.
The more people who are fearful and begin employing options or other financial strategies, the higher those prices will rise, and so the VIX will increase. Alternatively, if the VIX is quite low, it indicates that investors are now tranquil and confident regarding their investments. This is a straightforward explanation of how the VIX operates.
How Does the VIX Work?
There is no corporation that underpins the VIX; rather, the VIX is literally just a mathematical formula that is based on out-of-the-money calls and puts.
Understanding how the VIX actually operates is a difficult task. It essentially tells us where people expect the market to be in the future. Furthermore, the VIX can be used to forecast where the market will be in the future.
(The VIX calculation formula. Source: IG)
The VIX is estimated instantaneously by utilizing the current values of S&P 500 options; this covers both the normal CBOE SPX options, which mature on the third Friday of each month, and the once a week CBOE SPX options, that mature on the same day each week.
The VIX requires sophisticated math, but traders don’t need to learn it to trade it. By adding the weighted values of several put and call options across a broad variety of price levels, we can determine what prices investors are ready to purchase and sell at. The expected future volatility of the S&P 500 may be estimated using these final figures.
How Do You Use the VIX?
We know that we can use the VIX to determine where the market is currently headed. Simply put, when the VIX is starting to go up, it means we are going to see risks in the market, which means that the market may be going down.
On the other hand, if the VIX is going down, it means that the market is currently calm and there isn’t much risk involved in it. When the VIX goes down, the market goes up in simple terms.
As an investor, you should look at the VIX at the same time you plan to invest. These guidelines apply to both day traders and long-term investors. You should utilize the VIX to assess how the market is feeling and where it is heading, and make sure you purchase in the same direction as the market.
You should avoid investing large sums of money in the market as soon as the VIX rises, as this indicates that investors predict greater volatility in the future and that the overall market will fall.
(Historical graph of the VIX. Source: MacroTrends)
As can be seen on the cart located above, the VIX had two significant increases over the course of the last two decades. The first one occurred in 2008, during the height of the 2008 financial crisis, and the second one occurred in 2020, during the height of the COVID-19 pandemic.
How to Invest in the VIX
The VIX has made volatility marketable via derivatives. Cboe offered VIX futures in 2004 and options in 2006. These VIX-linked products introduce a new asset class by allowing pure volatility exposure.
Professional traders, major investment firms, and financiers utilize VIX-linked instruments for asset allocation. Because historical information shows a strong negative association between volatility and share price results, meaning when stock returns go down, volatility rises, and vice versa.
As with other indices, the VIX cannot be purchased directly. Traders can instead invest in VIX through futures and options contracts, as well as exchange traded products (ETPs).
Investors that utilize their own trading methods and complex algorithms price derivatives associated with high beta equities using VIX readings. Beta indicates the extent to which the value of a specific stock may fluctuate relative to a wide market index.
Frequently Asked Questions (FAQ)
Can I trade the VIX?
Similar to other indexes, the VIX can’t be purchased directly. The VIX may be exchanged via futures contracts, exchange traded funds (ETFs), and exchange traded notes (ETNs) that hold such futures contracts.
Where can I find the VIX?
You can quickly get a chart for the VIX by doing a simple Google search. It is denoted by the ticker symbol VIX. On Questrade, the symbol is VIX.IN, whereas on Stockcharts.com, it is $VVIX. It may vary on various charting sites, but it is still readily accessible.
Takeaways
- The VIX is essentially a fear measure; it provides a snapshot of the market’s attitude at any given time frame.
- To begin with, the actual name is the CBOE Volatility Index, which stands for the Chicago Board Options Exchange Volatility Index.
- There is no corporation that underpins the VIX; rather, the VIX is literally just a mathematical formula that is based on out-of-the-money calls and puts.
- By adding the weighted values of several put and call options across a broad variety of price levels, the VIX determines what prices investors are ready to exchange at.
- Simply put, when the VIX is starting to go up, it means we are going to see risks in the market, which means that the market may be going down.
- On the other hand, if the VIX is going down, it means that the market is currently calm and there isn’t much risk involved in it.
