Comprehensive guide to the VIX index, also known among traders as the "fear" index. Here’s what it is, how it works, and why it’s closely watched by traders and investors
What is VIX index? What does it measure, how does it work and how should it be interpreted?
The VIX estimates the implied volatility of options (calls and puts) on the S&P 500, offering a forecast of stock market volatility over the next 30 days. Simply put, it is one of the key market indicators often used as a investor fear barometer and market confidence.
First introduced in 1993 by the Chicago Board Options Exchange (CBOE), the world’s largest options exchange, the VIX Index was originally designed to measure the expectation of 30-day implied volatility in the prices of the at the money options of the S&P 100 index.
In this article, in collaboration with XTB experts, we look in detail to understand what is the VIX and why it is important for financial market operators.
What is the VIX index
In short, the VIX Index , also known as the "fear index," rising could indicate that investors are concerned about stock market volatility. The VIX measures the expected volatility of the US stock market over the next 30 days.
Specifically, the VIX measures the volatility implicit in options, both call and put, on the S&P 500 index. It is the expression of the variability expected by operators regarding the main US stock index. The higher the VIX is, the greater the perception of risk present on the market will be, so much so that in financial jargon the benchmark has earned the nickname of index of "fear".
In 1993, the birth year of the VIX index, the basket of reference options consisted only of eight calls and eight puts on the S&P 100. Since 2003 it has used the largest index and a greater number of options (both call and put) as a reference, so as to more effectively describe investors’ expectations on the future volatility of the US stock market.
Why is implied volatility important? Implied volatility is one of the determining factors in option pricing. For this reason, the higher this variable is, the higher the option premium will be, as the greater the earning possibilities.
Implied volatility is an estimate of future prices that has nothing to do with current prices. Even if investors take into account the implied volatility in their investment decisions, causing it to have a direct impact on today’s price level, there is no guarantee that future price expectations will actually be realised.
What is the VIX index for
The VIX is an important indicator because investors tend to prefer stable markets to volatile markets. Stable markets allow investors to make more accurate predictions about market direction, while volatile markets make predictions more difficult. A high VIX tends to make investors more cautious and willing to make less risky investment decisions.
How VIX works
The VIX uses a algorithm to calculate the implied volatility of US stock market options. Implied volatility is the future volatility an investor expects based on the options they buy.
The VIX calculates the implied volatility of put and call options at the average of the S&P 500 and expresses it as an annualized rate. For example, if the VIX is 20%, it means investors expect the US stock market to see 20% volatility over the next 30 days.
The VIX is considered a fear indicator as it tends to go up when the stock market goes down. When investors feel uncertain about the stock market, they tend to buy put options to protect themselves from price volatility. If the stock price falls, the value of the put option will increase. Investors expect the stock price to fall. When an investor buys a large number of put options, the price of the option increases, resulting in an increase in the VIX.
On the other hand, when the stock market is rising, investors tend to buy call options to take advantage of price movements. The value of the call option increases as the share price increases. In other words, investors expect the stock price to rise. When an investor buys a large number of call options, the price of the option increases, which in turn causes the VIX to decrease.
The VIX is closely associated with financial crises and is used by experts and analysts to predict the health of the economy. For example, the VIX reached an all-time high in 2008 during the global financial crisis. The VIX began to rise in 2007 as investors worried about the collapse of the US housing market and subprime mortgages. The VIX continued to climb until it peaked at 80.86 on November 24, 2008, as the financial crisis peaked.
Investors can use VIX to determine how risky a portfolio is and whether market exposure should be adequate. For example, when the VIX is high, investors may consider reducing exposure to the equity market or increasing exposure to more defensive assets such as government bonds and gold.
Interpretation of the VIX index
Financial market operators observe the VIX paying particular attention to the threshold of 25-30 points. This is traditionally the critical threshold that demarcates a low volatility condition (market optimism) from a high volatility scenario (market tension), which is generally associated with a decline in equity markets.
However, it is good to keep in mind that the "fear" index does not necessarily describe the fear of a drop in stock markets. The volatility described by the VIX is to be understood in both directions, therefore also upwards.
Basically, during periods of great uncertainty, the fear of a sharp drop in the price level stimulates the demand for put options, useful in order to hedge against any falls by blocking the sale price. This leads to an increase in their implied volatility and therefore in the value of the VIX index.
Conversely, during bull market periods there is more trust among traders, who have less need to hedge against a possible stock market crash. In these phases the VIX generally tends to stay at levels below 20.
The limitations of the VIX index
However, the VIX is not a perfect metric. Here are some caveats investors should consider when using the VIX as an valuation tool.
First, the VIX cannot always predict accurately stock market volatility. In some cases, the VIX can rise even when the stock market is stable or rising. This can occur when investors want to hedge against uncertain future events such as a general election, trade wars or geopolitical tensions. Additionally, the VIX can be affected by external factors such as Federal Reserve policies and geopolitical events. For example, when the US Fed raises rates, the VIX tends to rise. That’s because investors worry about the impact of rate hikes on the economy and stock markets.
XTB is an investment broker world-class regulated, with a global presence in over 13 countries. This financial intermediary is regulated by major financial regulatory institutions. The XTB platform offers access to more than 5,800 financial instruments - both real shares and ETFs, as well as CFD-type derivative instruments, as well as access to comprehensive and free training.
In collaboration with XTB
Original article published on Money.it Italy 2023-02-22 15:35:00. Original title: Indice VIX: cos’è e come funziona? Guida completa
