What is the CBOE Volatility Index (VIX)?

The CBOE Volatility Index (also known as the VIX) is an index designed to track the volatility of the United States stock market. Specifically, it aims to track the expected volatility of the S&P 500 via call and put options.

Definition of CBOE Volatility Index (VIX)

The VIX is an index created by Cboe Global Markets in 1993 that tracks how volatile the United States stock market is and is expected to end soon. It is widely used worldwide as a measure of stock market volatility, with higher levels in the VIX indicating more volatility.

Like other indexes, which track the performance of a basket of stocks or other securities, the VIX measures volatility by tracking a basket of securities. The VIX tracks calls and put options on the S&P 500 with an expiration date of 30 days from the current date.

  • Alternative names: Fear Gauge, Fear Index

The formula for calculating VIX is very complex. In short, as the demand for put options rises, the VIX will rise, as that implies investors expect more volatility going forward.

How Does the CBOE Volatility Index (VIX) Work?

The CBOE Volatility Index is used to track the expected volatility of the stock market based on changes in the price of S&P 500 options. Using a complex formula, the VIX rises when stock market volatility is expected to increase, and falls when volatility is expected to decrease.

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The VIX is often used as a measure of investor confidence and fear. If investors are worried about the market, the VIX will go up. When investors are convinced, it will fall. This has led many to call it the “Fear Gauge.”

Investors can trade derivatives based on the VIX, which can be useful for a variety of reasons.

For example, if an investor believes the stock market will be more volatile in the future, they can buy VIX futures to buy VIX at a higher price than the current price. Similarly, if they predict that volatility will fall, they can use derivatives to profit from that scenario as well.

Investors often use VIX as a way to protect their portfolios. Historically, the VIX has had a negative correlation with stock market performance. This means that in general the VIX will go up when the market goes down, and go down when the market goes up.

Although historically the VIX has moved in the opposite direction of the stock market, there have been situations where it has moved in tandem with the market, so investors cannot rely on it as a foolproof method of protecting their portfolios.

Investors who wish to use the VIX as a hedge can buy call options or sell put options against the VIX. If the market goes down, the VIX is likely to rise, allowing investors to profit from options, recouping some of their investment losses.

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Do I Need a CBOE Volatility Index (VIX)?

The VIX is a unique index that gives investors access to investment strategies that are difficult to implement in other ways.

If you believe that market volatility and investor fear will increase, VIX gives you a way to profit from those predictions. It can be difficult to invest in a way that will help you profit from volatility without using VIX based securities and derivatives.

Other investors use the VIX as a measure of investor fear and an indicator of the stock’s future performance. The uptrend in the VIX tends to indicate more investor fear, which could indicate a future decline in stock prices. Even if you are not involved in VIX based securities and derivatives, you can use the index as a useful indicator for other trading.

What It Means for Individual Investors

Individual investors can use the VIX in many ways. The simplest way is as an indicator of the overall forward market movement. Since the VIX tends to track investor sentiment, you may be able to identify future gains and losses in the market as a whole based on moves in the VIX.

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Some individual investors may wish to invest directly in VIX. While you can’t buy stocks in the index, you can invest in VIX derivatives or even trade traded products that track VIX.

VIX Futures

While trading derivatives is generally considered riskier than stocks, VIX futures tend to face a special risk: contango. In contango, futures contracts based on the VIX tend to be priced higher than the current VIX or short-term contracts. If your goal is to invest in VIX as part of your portfolio, you will end up buying more expensive futures contracts because the current contracts in your portfolio expire.

VIX Exchange Traded Products

Individual investors looking to avoid the hassle of options and other derivatives may want to buy shares of products traded on the VIX exchange when they expect the market to be volatile.

These products can be exchange-traded notes (ETNs) or ETFs structured as joint investments or limited partnerships.

Key Takeaways

  • The VIX is an index that measures the expected volatility of the stock market.
  • The VIX measures volatility using call and put options on the S&P 500 with a 30 day expiration.
  • Investors cannot invest directly in the VIX but can invest in ETFs that track it or derivatives based on it.
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