Everybody knows that the stock market goes up and down. But sometimes it goes up and down more — and faster than at other times.
Now, you can look at a stock chart and figure that out. However, stock and option traders require more precise measurements. Therefore, in 1993 Robert E. Whaley of Duke University developed The Chicago Board Options Exchange Volatility Index. VIX is its New York Stock Exchange ticker symbol, and how everybody refers to it.
The CBOE back-calculated its values to January 1986. It was originally tied to the implied volatility of S&P 100 Index (OEX) options, but in 2004 changed to the volatility of S&P 500 Index (SPX) options.
The exchange takes a sample basket of options and calculates their average as though they had thirty calendar days left until expiration.
There are other, related indexes. For instance, there’s the VXO index, also called the “old VIX,” because it’s calculated the same as it used to be, on the S&P 100 Index. There’s also VXN, which is the volatility measure based on the NASDAQ 100 Index options, which is similar to the QQV based on the options of the NASDAQ 100 Index Tracking Stock (QQQ).
It tends to rise when stock market prices are declining. That’s because some people, when afraid of a falling market, buy puts as “portfolio insurance.” Other people are attracted to options to try to take advantage of the ups and downs. And when implied volatility goes up, so does the money received from selling calls and puts. Bear markets cause an increase in fear and uncertainty, causing people to buy and sell for more emotional reasons. It’s therefore been known as the “fear index.”
During a bull market, however, there’s more confidence (leading to greed), causing less use of options and therefore a decline.
Traditionally, the two extremes have been at 20 and 35. A reading of 20 is quite low, indicating an extreme of bullishness. A measure of 35 is quite high, indicating an extreme of fear and bearishness.
Traders have tended to use it as a contrarian signal, therefore. When it is historically low, the market must be close to its high and, therefore, it’s time to sell. When it is historically high, the market must be close to its low and, therefore, it’s time to buy.
However, changes in market direction do not come immediately, so it is not a good timing signal.
If you believe you can tell that it is either too high or too low, there’re ways for you to speculate on the index itself. You can buy or sell VIX futures contracts, beginning 2004. You can buy or sell exchange-listed options, as of February 2006. You can buy or sell futures exchange traded notes from Barclays iPath as of February 2009.
You must also keep in mind that, mathematically, volatility can mean price rises just as much as price drops. During a bull market call option sellers should demand a higher premium, driving up implied volatility.
Therefore, in theory anyway, a high VIX can also mean a bull market, especially an extreme one.
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