What is the VIX (Volatility Index) and How to Use it

The CBOE Volatility Index (VIX) is a key barometer that investors and traders use to gauge expected volatility in the stock market. The VIX is calculated using front-month options in the S&P 500 index, and therefore reflects the market's perception of risk based on the ever-changing demand for these 30-day options. 

When investors are fearful or uncertain about the future direction of the market, the aforementioned options tend to increase in value. For this reason, the VIX is commonly referred to as the “fear gauge,” or the “fear index.” 

For context, the long-term average in the VIX is around 19, and it has ranged historically between roughly 9 and 82. In spring of 2020, when the stock market dropped precipitously during the onset of the COVID-19 pandemic, the VIX set a new all-time closing high of 82.69 on March 16, 2020. 

Generally speaking, higher levels in the VIX (>19) indicate that the options market expects elevated levels of volatility, while lower levels in the VIX (<19) indicate that the market expects lower levels of market volatility. As such, the VIX provides a real-time indication of expected volatility in the stock market.

In addition to the well-known VIX, which reflects the market’s expectation for volatility over the next 30 days, investors and traders can also monitor expected volatility over a wider range of timeframes. These include the 1-year VIX, 6-month VIX, 3-month VIX and 9-day VIX and even the 1-day VIX. The latter has become popular due to surging interest in so-called “zero-day” options (aka 0DTE options). 

Over the years, the VIX has become a widely recognized and closely monitored indicator, earning its reputation as the "fear gauge” due to its tendency to rise during periods of heightened uncertainty or market turmoil.

Market participants often use the VIX to assess sentiment in the financial markets, and at times to help with trading decisions. Notably, the VIX index itself can’t be traded, but VIX futures and options can be traded. The VIX is an important benchmark for other volatility-related financial products, as well. 

Historically, the VIX shares a relatively strong inverse correlation with the S&P 500. When the S&P 500 index experiences significant declines, indicating increased market volatility and uncertainty, the VIX tends to rise. Conversely, when the S&P 500 index rallies or trades sideways, the VIX often trends lower. 

Traders and investors closely monitor the relationship between the VIX and the S&P 500 as it provides valuable insights into market sentiment and risk. The inverse correlation between the two can inform trading strategies and portfolio adjustments, helping market participants navigate changing market conditions with greater insight and confidence.

The VIX calculation process is complex and involves sophisticated mathematical modeling techniques. But in simple terms, it involves a multi-step process that utilizes options prices to derive a measure of expected volatility in the S&P 500 index. 

The VIX calculation primarily relies on the prices of options contracts in the S&P 500 index with more than 23 days, and less than 37 days, to expiration. These options are selected because they capture the market's short-term expectations of volatility.

The process starts by selecting a range of at-the-money (ATM) and out-of-the-money (OTM) put and call options on the S&P 500 index. These options are then grouped into two categories: those with relatively shorter time to expiration and those with relatively longer time to expiration. Next, the implied volatility for each option is determined using an iterative process. This process involves finding the volatility level that, when plugged into an option pricing model (such as the Black-Scholes model), results in a theoretical option price that closely matches the observed market price.

Once the implied volatilities for the selected options are determined, they are then assigned a weight based on their contribution to the overall VIX calculation. Options with higher trading volumes and open interest receive higher weights, because they are deemed to be more reflective of market sentiment. The final step involves averaging the weighted implied volatilities of all the options, which ultimately represents the market's expectation of 30-day volatility in the S&P 500 index. 

Most market participants use the VIX as a general gauge of market volatility, and for insight into investor sentiment. Some investors and traders also use the VIX as an indicator for the purposes of speculation or hedging. 

Importantly, the VIX reflects expected volatility in the stock market, but actual volatility can be vastly different than the market’s expectations. That’s why many options traders also track actual volatility, which is sometimes referred to as “historical volatility.” 

Since its inception, the VIX has averaged roughly 19. That means when the VIX is trading in the low teens, the market’s attitude toward risk is more complacent. On the other hand, when the VIX spikes toward 20 and above, that indicates that anxieties are intensifying in the financial markets.

Accordingly, some market participants use the VIX as a trading signal. For example, when the VIX is elevated, implied volatility also tends to rise across the options market. As such, some market participants use extremes in the VIX (highs and lows) as an indicator for buying or selling volatility in the options market. 

It’s important to note that the actual VIX index can’t be traded, instead market participants use VIX futures and VIX options, or the options associated with single stocks and ETFs. Together, these instruments can be used to express a wide range of market opinions, whether the goal is to speculate or to hedge. 

Volatility products like the VIX offer diverse avenues for trading and expressing a wide range of market opinions, which can be advantageous for investors and traders active in this niche. However, their complexity can also increase the level of risk involved, because navigating these products requires a solid understanding of market dynamics and the specific intricacies of volatility trading.

As a result, many investors and traders elect to mock trade (e.g. paper trade) volatility-focused financial instruments prior to deploying “live” positions in the market. Mock trading refers to a simulated trading process where investors and traders practice buying and selling without using real money.

Overall, mock trading serves as a valuable educational tool for investors and traders of all levels, offering a low-pressure environment to gain practical experience before transitioning to live trading with real money. Mock trading allows traders to identify strengths and weaknesses, develop disciplined trading habits, and refine their trading strategies, ultimately improving their chances of success in the financial markets.

In addition to mock trading, investors and traders typically call on their past experience, as well as their current outlook, to craft strategies and approaches suitable for volatility-focused instruments. It’s important to note that many market participants use elements of different disciplines, not just a single discipline, when trading volatility instruments, whether it be VIX options, VIX futures, or single stock/ETF options. 

While there’s no set approach to trading volatility products, some of the more common strategies utilized in this niche of the financial markets are detailed below:

• VIX Futures: One way to trade the VIX is through futures contracts, which track the expected future value of the VIX. Traders can go long (buy) VIX futures contracts if they anticipate an increase in market volatility or short (sell) VIX futures contracts if they expect volatility to decrease. 

• VIX Options: VIX options provide investors and traders with a way to directly bet on, or hedge against, changes in the VIX. Market participants can purchase call options on the VIX if they expect volatility to increase, or buy put options if they anticipate a decline in volatility. Conversely, traders can also sell options in the VIX, for the purposes of speculation or hedging. 

• VIX Exchange-Traded Products (ETPs): Exchange-traded products linked to the VIX, such as exchange-traded notes (ETNs) and exchange-traded funds (ETFs), provide investors with exposure to VIX-related returns. These products can be traded on stock exchanges like individual stocks, allowing investors to gain exposure to the VIX without trading VIX futures or options contracts. One example is the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX). 

• Volatility Trading Strategies: Various volatility trading strategies involve using VIX-related instruments to capitalize on changes in market volatility. For example, volatility dispersion, which seeks to exploit differences in volatility levels between individual stocks and ETFs/indices. Other strategies, such as volatility spreads or straddles, involve trading options on the VIX, or VIX-related products, to profit from anticipated changes in volatility levels.

• Risk Management and Hedging: Investors can also use volatility products as part of their risk management and hedging strategies to protect against adverse market movements. For example, buying VIX calls ahead of a market correction. 

Before engaging in trading or investing in volatility products, it's essential to conduct thorough research and understand the risks involved. Volatility products can be highly volatile and complex, requiring careful consideration of factors such as leverage, liquidity, and rollover costs. 

Additionally, traders should stay informed about market dynamics, macroeconomic factors, and geopolitical events that can influence movement in volatility-focused products such as the VIX. As outlined previously, it can be prudent to mock trade these products before deploying “live” positions. 

The CBOE Volatility Index (VIX) is a volatility index derived from S&P 500 index options prices, while the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) is an exchange-traded product that aims to track the performance of short-term VIX futures contracts. The VIX represents the market’s expectation for future 30-day volatility, while the VXX provides investors with a way to access exposure to near-time changes in VIX futures prices. 

More details on these two products are outlined below:

CBOE Volatility Index (VIX) 

• The VIX is a measure of expected market volatility derived from options prices on the S&P 500 index.

• The VIX reflects investors' consensus expectations for future volatility over the next 30 days.

• The VIX itself is not tradable, but it serves as the basis for various volatility-related products, including futures, options, and other exchange-traded products.

• The VIX is often referred to as the "fear gauge" or "fear index" due to its tendency to rise during periods of market uncertainty, and fall during periods of market stability.

iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX)

• The VXX is an exchange-traded note (ETN) that seeks to track the performance of short-term futures contracts on the VIX.

• The VXX provides investors with exposure to changes in the prices of near-term VIX futures contracts.

• THE VXX aims to mirror  the market's expectation of short-term volatility in the S&P 500 index.

• The VXX is a tradable security that can be bought and sold on stock exchanges like an individual stock or ETF.

The long-term average in the VIX is around 19, and it has ranged historically between roughly 9 and 82. 

Generally speaking, higher levels in VIX (>19) indicate that the options market expects elevated levels of volatility, while lower levels in the VIX (<19) indicate that the market expects lower levels of market volatility. As such, the VIX provides a real-time indication of expected volatility in the stock market.

There’s technically no “good” number for the VIX, because one’s perception of the VIX depends heavily on individual factors such as portfolio composition, trading strategy, market outlook, and risk tolerance. What may be considered a favorable level of the VIX for one investor/trader might not be the same for another.

More context on how an individual investor or trader might view a “good” number in the VIX is highlighted below:

• Portfolio Composition: If your portfolio is heavily invested in stocks, a lower VIX might be favorable because it generally corresponds to a more stable market, which can be beneficial for long-term investments. Conversely, if you have a more diversified portfolio that includes assets like bonds or commodities, your tolerance for volatility might be higher.

• Trading Approach: For short-term traders or day traders, an elevated VIX might be preferred, because this type of trading environment can be characterized by higher-magnitude price swings, consequently offering a greater number of potential trading opportunities. Alternatively, long-term investors may prefer a lower VIX, thus reducing the risk of high-magnitude swings in the market. 

• Market Outlook: Bullish investors may prefer a lower VIX, because low VIX environments are typically associated with bullish market sentiment and reduced risk. Conversely, bearish investors and traders may view an elevated VIX environment as an opportunity to book greater profits, because the VIX usually spikes during corrections. 

• Risk Appetite: An investor/trader’s individual risk tolerance can also play a significant role in determining what constitutes a "good" VIX. Conservative investors with low risk appetites may prefer it when the VIX is trading below its long-term average, indicating lower market volatility and perceived stability. Conversely, aggressive investors with greater appetites for risk may desire market environments characterized by an elevated VIX, viewing it as an opportunity to achieve higher levels of return due to increased market volatility.

Ultimately, there is no universally "good" number for the VIX, because each investor or trader’s perspective on the VIX will depend heavily on his/her individual circumstances and preferences. 

A low VIX environment generally indicates that investors are somewhat complacent and expect minimal volatility in the near future. However, what constitutes a "low" VIX can vary depending on market conditions and individual perspectives.

In general, a VIX below 15 is often considered low, suggesting that investors expect relatively calm market conditions. Along those lines, some market participants consider a VIX below 12 as exceptionally low, indicating a high degree of market complacency.

On the other hand, it's essential to interpret the level of the VIX in the context of historical volatility and market conditions. For instance, during periods of economic and financial stability, a VIX below 15 might be considered low. But during periods of heightened geopolitical uncertainty, or a severe market correction, a VIX of 20-25 might be considered low. 

Ultimately, one’s interpretation of a “low” VIX is subjective, and dependent on a variety of factors. 

An elevated reading in the VIX typically indicates that investors expect significant market volatility in the near future. However, what constitutes a "high" VIX can vary widely depending on prevailing market conditions and an individual’s unique market perspective. 

In general, a VIX above 20 is often considered high, suggesting that investors anticipate increased market turbulence. Along those lines, a VIX above 30 or even 40 might be viewed as exceptionally high, indicating a high level of fear and uncertainty in the market.

Similar to interpreting a low VIX, it's crucial to consider the level of the VIX in the context of historical volatility and prevailing market conditions. During periods of economic stability or low uncertainty, a VIX above 20 might be considered high. However, during times of extreme market stress or crisis, a VIX of 20-25 might be considered only moderately high. 

Ultimately, one’s interpretation of a “high” VIX is subjective, and dependent on a variety of factors.