In-depth analysis of the VIX index: volatility indicator every investor must understand

Why Do Traders Pay Attention to VIX?

In the global financial markets, the VIX is one of the most closely watched volatility measurement tools. Many investors refer to it as the “Fear Index” because it tends to rise when the stock market declines. Understanding this indicator is crucial for traders who want to protect their portfolios from market fluctuations.

So, what is the VIX index? Simply put, it reflects market participants’ expectations of future price volatility. When investors are worried about a market downturn, they tend to buy protective instruments, which drives up the VIX value.

Core Concepts of Volatility

Before understanding the VIX, it’s essential to grasp the meaning of volatility. Volatility measures the extent of price fluctuations of an asset within a specific period. For example, a stock that fluctuates by 2% daily has higher volatility than one that only fluctuates by 0.5% daily.

There are two main ways to measure market volatility. The first is historical volatility, calculated by examining past price changes. The second is implied volatility, derived from options prices, reflecting investors’ expectations of future volatility. Implied volatility is important because options pricing inherently incorporates market participants’ views on future price movements.

Origin and Development of the VIX Index

The Chicago Board Options Exchange (CBOE) launched the VIX in 1993, making it the first official index designed to measure market volatility. Initially, the index was based on options data from the S&P 500 stock index (representing the 500 largest publicly traded companies in the US).

How does the VIX perform in practice? Under normal circumstances, the VIX in the US stock market fluctuates between 10 and 25 points. However, during extreme market conditions, the situation can be very different. During the 2008 financial crisis, the VIX surged past 80 points. Similar extreme volatility occurred during the COVID-19 pandemic outbreak in 2020. These peaks mark moments of extreme investor panic.

Inverse Relationship Between VIX and the Stock Market

When comparing the VIX with the S&P 500, a clear pattern emerges: they almost always move inversely. When the stock market rises, the VIX falls; when the stock market declines, the VIX rises. This inverse relationship is driven by the dynamics of the options market.

Options are essentially risk protection tools. When stock prices start to fall, traders increase demand for protective options (put options). As buying activity increases, the prices of these options rise, which in turn pushes up the implied volatility measure. Since the VIX is calculated based on the implied volatility of these options, it naturally increases when investors seek protection.

Methods and Process of VIX Calculation

What is the basis for calculating the VIX? It relies on S&P 500 index options, especially those with 23 to 37 days until expiration. This range includes traditional monthly options (expiring on the third Friday of each month) and weekly options.

During the calculation, options with no trading activity are excluded to ensure data validity. If there are no trades for two consecutive strike prices, all subsequent options are also excluded. This dynamic process means the set of options used to compute the VIX is constantly changing, which is why the VIX cannot be manually calculated and requires real-time complex mathematical processing by computers.

Using VIX for Investment Protection and Strategy

Because the VIX tends to rise during market downturns, many investors use its derivative products as portfolio insurance. There are VIX options and VIX futures that allow traders to directly bet on volatility. Additionally, exchange-traded funds (ETFs) tracking the VIX index are available.

However, it’s important to emphasize that these derivative products carry high risks. They can involve significant costs and may result in losses exceeding the initial investment. Therefore, such tools are not suitable for inexperienced investors.

Global Volatility Index Family

In addition to the VIX based on the S&P 500, CBOE has developed various other volatility indices. These track volatility for companies listed on the NYSE and NASDAQ. The Dow Jones Index and Russell 2000 (which includes US small-cap stocks) also have corresponding volatility measures. Moreover, European markets and other regions have launched similar volatility indicators, providing investors with more nuanced insights into market sentiment.

These diverse volatility tools enable investors to more accurately assess risk levels across different market sectors.