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The Chicago Board Options Exchange ("CBOE") is the world's largest stock market/exchange that focuses on trading options. In 1993, the CBOE invented an index called the CBOE Volatility Index ("the VIX"). The VIX is an index that measures the prices of options on the S&P 500 stock index. Per the CBOE's website:
"The VIX index is an index of 30-day implied volatility as indicated by the prices of SPX option contracts. Implied volatility rises when the relative prices of options increase. Rising implied volatility is generally caused by an imbalance of demand for options from options buyers over supply of options from sellers. In contrast, volatility falls when the relative prices of options decline. Falling implied volatility is generally caused by an imbalance of supply of options from option sellers over demand for options from buyers. The daily change in the VIX index is an indication of how aggressively SPX option contracts are being purchased or sold."
Is that clear?? Not really, not to most people. In simple terms, the VIX measures how expensive options are on the S&P 500 stock index. All stock options go up and down in price on a daily basis as the price of the underlying stock (or S&P 500 index) changes on a daily basis. But stock options also go up and down in price for other reasons. The options market is a different market than the stock market (literally), and so there are times when the price of options will be going up or down in a pattern that is different than the actual stock market itself. So the VIX was originally invented as a way to measure how expensive or cheap the options market is (using options on the S&P 500 index as a barometer).
Where does the fancy term "volatility index" or "implied volatility" come from, if the VIX index is really just a measure of the pricing of stock options? The theory is that the primary reason that stock option prices go up or down is that investors' expectations of the future volatility of the stock market are going up or down. An investor that buys a stock option (or option on the S&P 500 index) is betting that the stock itself (or the index) will go up or down, and generally you only make money on a stock option if the stock price goes up or down in a significant way. The odds of a particular stock's price going significantly up or down are greater if the overall stock market is going significantly up or down. So in theory stock options are more valuable in a market where stock prices are going up or down in a dramatic fashion (i.e. if the market is volatile).
So, the theory goes, if on average stock option prices go up or down, investors must be assuming that the stock market going forward is going to be more or less volatile. So if the CBOE VIX index goes up, it "implies" that the people buying the options must be assuming that the market going forward is going to be more volatile. It's not a perfect theory - and thus the use of the term "implied volatility" - but it's generally correct.
In most online finance websites you can pull up the VIX index in a stock chart using the following symbols:
* We use the symbol VIX
* At Yahoo Finance use ^VIX
* At Schwab use $VIX
* At Fidelity use VIX
* At Google Finance use VIX
Although it measures something straight forward (the price of options on the S&P 500 index), the VIX has become more than just an index. Many people track the VIX as a symbol of investor fear or confidence in the market. Why?
As you can see from the chart below, generally speaking, the VIX index goes up or down in the opposite direction of the U.S. stock market (as measured here by the EFT SPY). If the stock market is having a good period where it is going up, the VIX generally will go down during such period. If the stock market is having a down period, the VIX generally will go up during such period.
Chart 1 - Daily change during the past year in the VIX Index versus the S&P 500
Why does this happen? Again, per CBOE's website:
"A frequently-asked question is, "Why do SPX and the VIX index move in opposite directions?"The answer to this question is rooted in the nature of option trading that occurs on days when the market is down versus days when the market is higher. It seems that the "order flow" - the pace and types of orders that come into the marketplace - in SPX options is different on bullish days compared to bearish days.Consider a day when SPX is declining. On such a day, market participants may be looking for ways to protect their portfolios against further market declines. Since purchasing SPX put options is an easy and effective hedging mechanism, the increased demand for SPX put options causes the relative price and, therefore, the implied volatility of these options in increase. Since the VIX index is a measure of SPX implied volatility, the VIX index moves higher because of this increase in demand for SPX put options.Now consider the behavior of option market participants when the SPX is rising. SPX options traders do not seem to rush into buying SPX call options when the market is rising in the same way that they seem to plunge into buying puts when the market is falling. As a result, the order flow in SPX options on rising days seems to be more balanced between buyers and sellers. The result is steady or falling implied volatility of SPX contracts. And, again, since the VIX index measures this implied volatility, the VIX index tends to stay steady or decline on days when SPX rises. "
Therefore, the VIX index has become an important index that people follow. But because of the complexity, it is often misunderstood. It's also hard to determine cause and effect. Did the stock market go down because the VIX went up? Or did the stock market going down cause the VIX to go up? It's hard to say for sure, but generally the VIX responds to what is happening in the market, rather than an increase in the VIX causing the market to go down.
All data is a live query from our database. The wording was last updated: 04/29/2017.
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