If you have been following the market at all in the past few months you know what has been going on with the VIX and how customers, brokers, and traders have been going bananas over it. For the young, inexperienced, or “under a rock” investors who are not too familiar with what the VIX is or how it has been acting recently, you’ve stumbled down the right rabbit hole.
The options market is a relatively large and sometimes confusing world to wrap one’s mind around. There is a plethora of terminologies, strategies, and investment factors that must be considered before fully grasping the market and seeing how certain aspects relate to others.
One of these topics of understanding is the VIX. Everyone in the options market, stock market, and general finance world are bringing up this acronym in every conversation. The VIX stands for Volatility Index that the Chicago Board Options Exchange began calculating in 1993 and introduced into the options market in 2006. The Volatility Index tracks the movement of the S&P 500 Index (SPX) through various algorithms and derivatives and cranks out how volatile it thinks the market is at the moment.
Now I can hear you thinking to yourself right now and you need to pump the breaks. The VIX is not a market fortune teller, sadly. The VIX is not a perfect predictor of how the market will fluctuate but rather the calculation showing the likelihood of movement based on the previous market activity. It provides a value that shows the amount of uncertainty or risk about the size of changes in a securities value.
Historically, the VIX has been between the low 10’s (where it has been hovering recently) and as high as the mid 80’s back in 2009. The way to read the VIX algorithmic output is actually quite straight forward. When the index value is low, it means that it is likely that the market is not fluctuating too much and prices are relatively stable. However, when the value is high, the chances of the market changing dramatically increase.
Another way of considering the VIX is by its floor nickname of “the fear index.” It’s called this because it is essentially showing how risky or conservative customers in the market are willing to be based on market presence. The cool thing about this mathematical market gauge is that it does not just sit on the options board telling traders to hold on to their hats when the market moves, but the fact that it’s a tradable product at CBOE.
Through the various strategies brokers and traders prefer to implement towards their portfolios, basic long and short positions generally cover the spread of this index’s movement. The index average stays in the high teens and lower twenties so the typical strategy traders use to trade VIX is shorting it in various ways since the movement has a tendency to fall back to this comfortable area.
Becoming fully educated in market news, know-how, and market movement is a difficult task. Taking small steps, like understanding largely talked about subjects, such as CBOE’s Volatility Index, is useful for grasping the options market as a whole.
(editors note: Bennett will be a Senior at Loyola University of Chicago in September. He did a good job of explaining the VIX in layman’s terms for this article. This is his second contribution and we hope we can coax a few more out of him before he returns to school).