Understanding The VIX
Ever think about how experts talk about a market metric to people who really don’t understand what they are saying?
Take the VIX for example.
If you’ve been investing for the past 20 years, you might have learned about the VIX when it was first introduced in 2004 by the Chicago Board of Options Exchange (CBOE). But unless you’re a trader, you probably never really needed a deeper understanding. At least not in a bull market because, like they say…
“Everybody’s a genius in a bull market”.
But when the markets turn bearish, not understanding certain metrics matter. Even if all you’re doing is understanding why it doesn’t matter.
In a nutshell, the VIX is the most popular way to measure future volatility. It uses S&P 500® (SPX) option pricing. And it is designed to signal the level of fear or stress in the stock market.
To understand how the VIX is calculated, let’s imagine it’s currently at 20.
20 is the percent expected move in the S&P over the next year based on options trading by institutions hedging against the information they have. Basically, if you owned a stock you thought was going to go down, you could sell it or you could purchase “put” options to protect against a market drawdown.
So a VIX of 20 means the market expects the S&P to be up or down by 20 percent over one year.
Here’s the forward one-month calculation for the VIX at 20:
20 / the square root of 12 (months) = 3.46%.
Example: VIX of 20 /3.46 = the Market expects the S&P to move +/- 5.78% over the next 30 days
This calculation can be used for any timeframe, and we’ve created a handy reference guide to make it easy to compare the range of movement over different periods. Click here to get it.
As for exactly why it matters, when the S&P 500 comes under pressure, the demand for SPX “put” options increases, which often pushes the VIX higher. This is why they call the VIX “The Fear Index” because of the increased demand for portfolio protection during volatile times. And it has led to a belief that when the S&P goes down, the VIX goes up. In theory, this makes sense, because the long-term correlation is -0.75. However, 20% of the time, the correlation is 1.0, which means they move in the exact same direction.
When properly understood, market metrics like the VIX have the potential to let us see opportunities as they unfold. Within the proper context, they are useful tools when used as part of a comprehensive approach to fundamental analysis–especially in times of market turmoil.
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