What is the VIX index?

The VIX index is often called the fear index of the stock market. The index usually shoots up when there is turmoil and prices fall. Investors can hedge against that turmoil with financial instruments based on the VIX index and other volatility indices.

What is volatility?

Volatility in the investing world is the movement of the price of a financial instrument. It is a measure of how much the price goes up and down. For example, a stock that goes up or down an average of 1 percentage point per day has a higher volatility than a stock that goes up or down an average of 0.5 percentage points per day.

Historical volatility and implied volatility

There are several ways to measure volatility in the market. The first method looks back in time. Over a period of time it is determined how volatile the price of, for example, a stock was. This is called historical volatility. Another method is that of implicit volatility (also called implied volatility or expected volatility). This method looks ahead. This is done on the basis of the prices of options on an index. This is because option prices say something about the expectation that investors have of future price movements. By looking at these prices it is possible to measure what those expectations are.

More volatility in a falling stock market

Increases in the stock market are almost always gradual. But when the stock market falls, it often does so with large shocks and sharp price reductions. Therefore, the volatility in a falling stock market often shoots up. The American VIX index on the S&P 500 is usually between 10 and 25 points. However, during the financial crisis of 2008, the VIX reached positions beyond 80 points. This also happened in the spring of 2020 during the corona crisis. The highest intermediate position of the VIX index was reached in 2008, the highest closing position in the spring of 2020. Because volatility is much higher in bad times in the stock market, the VIX index is thus also called the fear index.

History of the American VIX index

The first volatility index was the US VIX index. The Chicago Board Options Exchange (CBOE) launched this index in 1993. The CBOE is an American options exchange. For the first few years, the index was based on options on the S&P 100, which is a sub-index of the S&P 500 containing the 100 largest companies listed on the US stock exchange. In 2003, CBOE and investment bank Goldman Sachs adjusted the calculation of the index. Since then, the VIX has been based on options on the entire S&P 500 index.

Calculation of the VIX Index

The calculation of the US VIX relies on index options on the S&P 500 that expire within a 23- to 37-day period. It considers both traditional options that expire on the third Friday of the month and options that expire weekly. Only options that are 'out of the money' are included in the calculation. An option is out of the money if the option does not yield anything when exercised. This is the case for a put option if the price of the underlying financial instrument is higher than the exercise price. For a call option, this is the case if the price is lower.

In addition, options on which there are no bids are excluded from the calculation. If there are two options with a successive strike price for which there are no bids, all subsequent options are also excluded. For puts, these are options with a higher exercise price, for calls they are options with a lower exercise price.

Because option prices move all the time, the composition of the basket of option series on which the calculation of the VIX is based can change in real time. This makes it impossible to calculate the VIX by hand. This is therefore done by computers.

Using the VIX as a hedge

Because the VIX rises in times of falling stock prices, it is possible to use financial instruments derived from the VIX index to protect against price losses. It is also possible to speculate on these price losses. There are VIX options and VIX futures on the index. In addition, there are leverage products such as Turbos and ETFs that make it possible to follow a volatility index. However, there are many risks associated with these types of products because of high costs or because you can lose more than your deposit. Thus, they are not suitable for the novice investor.

Contango

One problem with ETFs based on the VIX is that the price of future contracts for the VIX increases as the expiration date gets further away. This is called contango, and is a phenomenon known from the market for futures on commodity prices such as oil. The higher price for delivery in the future is the result of uncertainty about what might happen to the price in the meantime. In the case of commodities, this includes, for example, crop failures or the loss of some oil production. For the VIX, the uncertainty is how the stock market climate will develop.

The consequence of contango is that investors who work with futures repeatedly pay a premium for holding the same position. As a result, an investment using futures automatically decreases in value.

Variants of the VIX Index

In addition to the volatility index on the S&P 500, CBOE has a number of other volatility indices for gauges on the NYSE and NASDAQ. For example, there are volatility indices for the Dow Jones and the Russell 2000 that include smaller companies. There are also volatility indices that look at a shorter or longer time frame than the VIX for the S&P 500. European indices today also have these types of gauges. One example is the European Euro Stoxx 50 Volatility (VSTOXX). It is based on options on the Euro Stoxx 50. This is the European index with the fifty largest companies in Europe.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Please be aware that facts may have changed since the article was originally written. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.