Trading Guides Derivatives

What is the VIX Index?

By Stefano Treviso, Updated on: Apr 07 2023.

The VIX Index, also known as the "Fear Index," is a measure of expected volatility in the U.S. stock market and is often used as a gauge of investor sentiment and market risk.

The index was first introduced in 1993, and since then, there have been several instances where the VIX has spiked, indicating increased market volatility and uncertainty. Some notable examples include:

• 2008 Financial Crisis: During the 2008 financial crisis, the VIX spiked to its all-time high of 80.86 in November 2008, as investors were concerned about the stability of the global financial system.
• 2011 Debt Ceiling Crisis: In August 2011, the U.S. government faced a potential default as lawmakers struggled to reach an agreement on raising the debt ceiling. The VIX rose to 48 during this period of political uncertainty.
• 2020 COVID-19 Pandemic: The COVID-19 pandemic caused widespread market disruption in early 2020, leading to a sharp increase in the VIX. The index reached a record high of 82.69 in March 2020, as the extent of the pandemic's impact on the global economy became clearer.
• 2021 GameStop Trading Fiasco: In late January 2021, the VIX rose dramatically as retail traders on social media platforms coordinated to drive up the price of stocks such as GameStop, leading to increased market volatility and uncertainty.

These are just a few examples of instances where the VIX has spiked, reflecting increased market uncertainty and volatility. However, it's important to note that the VIX is just one measure of market sentiment and risk, and its fluctuations should be viewed in the context of broader market trends and economic developments.

How is the VIX calculated?

The VIX is calculated by using a complex formula that takes into account the prices of options on the S&P 500 index. The calculation involves using option prices to estimate the implied volatility of the S&P 500 over the next 30 days.

The Implied volatility is a statistical measure of the expected volatility of an underlying asset's price. It is implied from the price of options contracts that are traded on the asset and represents the market's expectation of the future range of the price movements of the asset.

Implied volatility is an important concept in options trading, as it helps traders determine the prices of options and assess the potential risks and rewards of different options strategies. By comparing the implied volatility of options on a particular asset to historical volatility or to the volatility of other assets, traders can make informed decisions about which options to buy or sell and at what strike prices.

Here's a high-level overview of the steps involved in calculating the VIX:

• Options prices on the S&P 500 index are collected, including both call and put options.
• The prices of the options are used to calculate the implied volatility of the S&P 500 index over the next 30 days. Implied volatility is a measure of the market's expectation of future volatility.
• The implied volatilities are then used to estimate the expected volatility of the S&P 500 index over the next 30 days.
• The expected volatility is then plugged into a pricing model, such as the Black-Scholes model, to determine the theoretical price of a hypothetical option that would have the same expected return as the options currently being traded on the S&P 500 index.
• The VIX is then calculated as the square root of the annualized expected volatility of the S&P 500 index over the next 30 days.

While most likely we're sure that you're not interesting in learning how to calculate the VIX Index by yourself, it is important to understand that the only objective is 

The good and the bad levels for the VIX Index

The CBOE Volatility Index, commonly known as the VIX, is a measure of the market's expectation of volatility over the next 30 days. It is calculated based on the prices of options on the S&P 500 index.

A VIX reading of less than 20 is generally considered to indicate a low level of volatility, while a reading above 20 is considered to indicate higher volatility.

An example of the VIX Index

Let's image for a second that Russia detonated the first nuclear bomb in the current Ukranian-Russian conflict. 

While it's difficult to predict exactly how the VIX index would respond to a hypothetical event such as a nuclear strike by Russia, it's likely that such an event would cause significant market turbulence and volatility, and the VIX index would likely reflect this.

Because the VIX is often used as a gauge of market fear and uncertainty, a major geopolitical event like a nuclear strike would likely cause investors to become more risk-averse, which would lead to increased demand for options that provide protection against market declines. As a result, the VIX index is likely to rise.

Bottom line, catastrophic events, can trigger a price increase on the VIX and the same process of those events weathering down will also trigger a price decrease on the VIX.

How to use the VIX Index?

Here are some interesting ways to use the VIX index in your favour as a trader:

• Hedging: If you are concerned about market volatility, you may use the VIX index as a tool to hedge your portfolio. One way to do this is to buy options on the VIX, which can provide protection against market downturns.
• Timing investments: Some investors use the VIX as a gauge of market sentiment, and use its movements as a signal for when to enter or exit the market. For example, a high VIX may indicate increased market uncertainty, and some investors may choose to reduce their exposure to stocks during these periods.
• Trading VIX-linked securities: There are also a variety of securities, such as exchange-traded notes (ETNs) and exchange-traded funds (ETFs), that are linked to the VIX and can be traded on major exchanges. Trading these securities can provide exposure to changes in the VIX index, and may provide a way to profit from market volatility.

Now, if you're wondering how to specifically trade the VIX, here are some potential ideas on how to do it:

• Long VIX: Buy VIX futures or exchange-traded products when the stock market is in a period of high volatility or when there is uncertainty in the market. The idea behind this strategy is that as market volatility increases, the VIX generally rises, providing a potential profit opportunity.
• Short VIX: Sell VIX futures or exchange-traded products when the stock market is calm and stable, and there is low volatility. The idea behind this strategy is that as market volatility decreases, the VIX generally falls, providing a potential profit opportunity.

Bottom line, the VIX Index is considered by many as an insurance against stock market crashes and can definitely be a valuable tool to have for a trader in the event of adverse market scenarios.