VIX index is something you may have heard in recent times.
Markets have been fairly volatile recently, and they tend to be turbulent before elections. Furthermore, there are growing fears about the prospect of a contested election or a delay in the release of the results.
The VIX, also known as the “fear index,” has just surged and may remain elevated until we have more clarity on the election outcome.
As a result, there has been a surge in interest in products that wager on volatility. Investors should keep in mind, however, that volatility ETFs are extremely complex securities.
The Cboe Volatility Index (VIX) is based on S&P 500 options.
Investors cannot directly invest in the VIX. Hence, traders use VIX options or futures contracts, as well as exchange traded products (ETPs).
These instruments are connected to VIX futures contracts.
The VIX and the S&P 500 index are normally negatively connected, and the VIX often rises when equities fall, but it soared even while the stock market rose in July and August.
What is the VIX volatility index?
VIX or the volatility index is a product of the CBOE or the Chicago board of options exchange. VIX was created in 1993 by Robert Whaley. Whaley was a professor at the Vanderbilt University.
The VIX is a leading indicator of volatility or uncertainty in the equity markets.
The VIX volatility index reveals the sentiment of the market in the short term. It is not surprising why it is called the fear index. The fear is the fear of the investors.
For you, as an investor, knowing how volatility index works can be beneficial. This information will assist short-term traders. More importantly, you can fine-tune your to make sense of the uncertainty in the markets.
People who follow VIX, understand that it represents the S&P 500 index. The S&P500 in turn represents the stock market, or a portion of it. The 500 blue chip companies in the index.
When VIX rises, it indicates that investors are reacting to increased uncertainty in the markets. This means that the S&P500 price turns more volatile.
When the VIX falls, investors bet on smaller price swings in either direction in the S&P 500 index. This suggests periods of lower volatility but more certainty of where the market is going.
It’s crucial to emphasize that, volatility might have negative implications. This includes:
- more risk
- increased stress
- higher uncertainty
- larger market drops
Despite the negative connotations, volatility is merely a statistical term.
Volatility measures the rate of change in the price of an asset, over a period of time.
Greater volatility indicates that an asset or investment has larger price changes—either higher or lower—over shorter time periods.
How VIX measures the volatility of the markets?
The VIX index tracks the trading of S&P 500 option prices to gauge volatility.
The VIX index tracks these trades to evaluate market volatility.
Investors use the options on the market index like S&P500 to hedge their portfolios. This allows investors to protect the portfolios against downside risks.
There are option contracts with expiration dates in the next month. Some contracts also expire on separate Fridays of the following month. But this can make the options market seem impenetrable.
However, the VIX index measures volatility by looking at strike prices associated with distinct puts and calls.
The S&P 500 index futures prices are weighted based on market expectations for gains and losses.
If the VIX index is below 12, investors consider the market to be in a low-volatility period.
When it comes to unusually high volatility, which is anything over 20. In such instances, the VIX readings above 30 indicates unrest in the markets. In other words, uncertainty. When uncertainty rises, investors sell before asking questions.
It’s critical that the VIX measures future or historical volatility. This is because it’s dependent on how much investors are ready to pay for the right to purchase or sell a company (call or put options).
Investors are willing to pay more for ‘insurance’ in the form of options when market risk is viewed as larger. Therefore, the higher the premium for an option, the greater the investor willingness to pay.
When stock prices are expected to take a major upswing or downswing, investors typically use options to ‘hedge’ their positions in order to limit risk.
Hedging is an insurance strategy in which an investor buys an option to take the opposite position in the stock from the one they already hold.
How to invest based on the VIX?
A spike in the VIX will communicate to investors that market volatility is likely to grow if option prices generally climb — signaling increased uncertainty and greater expected volatilities.
Market professionals use different methods and technologies to stay on top of the market. The VIX is one such tool, among other things.
It can determine when the equity markets are poised to make a significant move either up or down. Investors can also know when the market is ready to settle after a period of increased volatility.
Through the prism of reversion to the mean, experts interpret what the VIX is trying to tell them.
In the financial markets, mean reversion argues that asset prices tend to stay closer to the long-term average price.
In the event of dramatic price increases or decreases, the reversion to the mean theory suggests that prices will return to their long-term average within a short period of time.
The VIX index measures how far the S&P 500 index strays from its mean before returning.
A professional’s bet is that the equity markets may move higher or lower in the short term.
This is when the VIX remains relatively calm but stock prices spike upward.
Investors view reduced volatility as a mean reversion. This also indicates that the higher period of uncertainty is coming to an end.
Seeing the VIX rise as an investor could be an indication of future volatility.
Trading the VIX – Conclusion
Investing in less risky assets such as fixed income or treasuries can worth considering. This is true if you are risk averse.
Alternatively, you might change your asset allocation in recent gains to cash and put money aside in a bear market.
It may be prudent to focus on single equities or other risky assets which perform during a bull run. On the other hand safe haven instruments are a better bet during downturns in the market.