The Volatility Index (VIX) measures the market’s expectation of short-term volatility based on option prices on the S&P 500. It is expressed as an annual percentage and is sometimes referred to as an “investor fear indicator.”
VIX, created by the Chicago Board Options Exchange (CBOE) in 1993, is the Volatility Index. Measures the market’s expectation of short-term volatility as reflected in option prices on the S&P 500 stock index.
Implied volatility is an estimate of how much the price of a security is likely to move in a given period of time. VIX is constructed using the Black-Scholes option pricing model to calculate implied volatilities for a series of equity index options. These are combined to create a general measure of market expectations for near-term volatility. The index was originally built using the S&P 100 Index, but in 2004, the CBOE switched to the S&P 500 to capture a broader segment of the general market. To ensure continuity, the above calculation continues to be published under the name VXO.
The Black-Scholes model assumes that market movements can be expressed as a normally distributed probability function, better known as the bell curve. Visually, VIX is a measure of the height and width of the curve; a low number implies a tall bill shape, while a high number implies a short, broad shape. Mathematically, it is expressed as an annual percentage. A VIX of 15, for example, means that the market expects a 15% price change over the next year.
Professional options traders often choose to express VIX and other implied volatilities as a daily percentage. Because they are continually adjusting their positions based on market conditions, the biggest risk for them is when the markets are closed and adjustments cannot be made. Calculated as a daily percentage, VIX provides an estimate of how much the market may change between closing and reopening. The daily score can be approximated by dividing the yearly number by 16.
A lot of market knowledge has surfaced on VIX. It is sometimes referred to as an “investor fear indicator” because it has a tendency to rise sharply when markets are under stress. However, it is important to note that the index does not measure sentiment, it only measures implied volatility. Since implied volatility is most significantly affected by changes in real volatility, its increasing periods of market stress are not due to investor sentiment, but rather to rising real volatility.
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