VIX index: Why is volatility a mirror of market fears?

23, Dec - BLOG

Often referred to as the market fear index, the VIX index usually rises when the market is turbulent and prices are falling. Investors can hedge against these fluctuations by using financial instruments based on the VIX index and other volatility indices. Our article will explain what volatility is, review the history of the VIX index in the US, how it is calculated and how investors use it.

Historical and implied volatility

Volatility refers to fluctuations in the price of a financial instrument. It is a measure of how much the price of an asset rises or falls. For example, a stock whose price rises or falls by an average of one percentage point per day has higher volatility than another stock whose price rises or falls by an average of 0.5 percentage points per day. There are several ways to measure volatility. 

The first way involves going back in time. For example, we can determine the volatility of a stock's price over a certain period of time, which is known as historical volatility. The other method is implied volatility, also known as future volatility or expected volatility. This method is forward looking and is based on the price of options on an index. The methodology is as follows: option prices reflect investors' expectations of future price movements. By analysing option prices, investors' future expectations can be estimated.

High volatility in a bear market

Market rises are very often gradual, but on the other hand, when the market falls, the fluctuations are usually large. As a result, we often see high volatility in a falling market. For example, the US VIX index for the S&P 500 is usually between 10 and 25 points, but during the 2008 financial crisis, the VIX reached levels exceeding 80 points. The same thing happened in the spring of 2020 during the financial crisis associated with the coronavirus pandemic.

The highest level of the VIX index during the trading session was reached in 2008 and the highest level after the close of trading was reached in the spring of 2020. Because volatility is significantly higher during crises, the VIX index is also known as the fear index.

Calculation of the VIX index

The first volatility index was the US VIX index. The Chicago Board Options Exchange (CBOE) launched this index in 1993. In its early years, the index was based on options on the S&P 100, a sub-index of the S&P 500 that includes the one hundred largest companies listed on the US stock exchange. In 2003, the CBOE and investment bank Goldman Sachs changed the method of calculating the index. Since then, the VIX index has been calculated based on options on the entire S&P 500 index.

The calculation of the U.S. VIX Index is based on options on the S&P 500 Index that expire within 23 to 37 days. Traditional options expiring on the third Friday of the month and options expiring each week are included. Only out-of-the-money options are included in the calculation. An option is out-of-the-money if it earns nothing when exercised. This happens, for example, with a put option if the price of the underlying financial instrument is higher than the strike price. A call option, on the other hand, is exercised if the price is lower than the underlying asset.

In addition, no put options are excluded from the calculation. If there are two options with consecutive strike prices for which there are no bids, all subsequent options are also excluded: for puts, these are options with a higher strike price, for calls, these are options with a lower strike price. Since option prices are constantly changing, the composition of the basket of option series on which the VIX calculation is based can change in real time. Therefore, it is not possible to calculate the VIX manually, and this task is performed by computers.

Using the VIX as a hedge

Since the VIX rises in bear markets, it is possible to use financial instruments based on the VIX index to protect against falling prices. It is also possible to speculate on such a fall. There are VIX options and futures contracts on the VIX index, as well as leveraged products such as turbos and ETFs that track the volatility index. However, derivatives carry significant risks due to their high cost and the fact that you can lose more than your initial deposit. Therefore, they are not suitable for novice investors.

Contango effect

One of the problems with VIX-based ETFs is that the price of VIX futures contracts rises as the expiry date approaches. This phenomenon, also known as ‘contango,’ is familiar from the futures market for commodities such as oil. A higher future delivery price is the result of uncertainty about the price trend over a given time frame.

In the case of commodities, this is, for example, the risk of losing some oil production. For the VIX, the uncertainty is related to changes in market conditions. A consequence of the contango effect is that investors using futures contracts pay a premium several times higher to hold the same position. As a result, investments made using futures contracts are automatically devalued.

Varieties of the VIX index

In addition to the S&P 500 Volatility Index, the CBOE has developed several other volatility indices for the NYSE and NASDAQ indices. For example, there are volatility indices for the Dow Jones and Russell 2000 indices. There are also volatility indices that cover a shorter or longer period than the VIX for the S&P 500. European indices today also have a similar type of volatility index. One example is the Euro Stoxx 50 Volatility Index (VSTOXX), which is based on options on the Euro Stoxx 50. This is a European index of the fifty largest companies in Europe.

The Paris Stock Exchange also had a volatility index for the CAC 40 (VCAC). However, Euronext decided to abandon this index at the beginning of 2021. The volatility index no longer meets market expectations. The exchange plans to offer a new solution to allow investors to react to volatility on the Paris Stock Exchange.

Conclusion

The VIX index is a reflection of market psychology, fears and expectations of participants. Its dynamics allows you to assess risks and prepare for possible crises. Thanks to instruments based on the VIX, traders can hedge positions or make money on market declines. However, it is important to remember the high risks of using such tools, especially for beginners. Studying the VIX is a step towards turning chaotic market fluctuations into a predictable tool for analysis and strategy.