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If you ever listened to a TV pundit talk smart about the market, then the chances are good you’ve heard them mention VIX or “the volatility index”…

Some may even have used an unnerving term of “fear index of the market” when referring to it.

And in fact, it’s not just the TV people – plenty of Twitter guys will happily offer their thoughts on why the VIX is high or low and what it signals ahead.

It’s even possible you’ve heard Jason Bond mention this thing before.

Now, you may be rightfully wondering: What exactly is VIX, and why should I care?

Well, in my view, the VIX index is one of those things you may want to pay attention to.

Today, I figured I’d spend some time teaching you how it works and why it matters.

 

VIX is Based on Implied Volatility

I’d assume that most of you have a pretty good idea of what volatility is, but in simple terms: it’s a measure of how much an asset jiggles around.

A $100 stock with a historical daily average move of $1 in either direction doesn’t seem too volatile.

But average daily moves of $8 on a $100 stock may not be that easy to stomach – traders would generally call it highly volatile.

Obviously, we can only measure historical volatility – after it took place.

Therefore, to assume the future, we rely on past figures and arrive at “implied volatility” or IV – our expectation for how much a stock may move based on how it’s moved historically.

IV is a term most commonly heard in the options markets, as the pricing of options is highly dependent on what the market expects for the underlying asset: options on more volatile assets will command a much higher premium than those on less volatile ones.

And this is exactly where the VIX comes into play…

VIX is a Product of SPY’s IV

As you may be well aware, SPY – the most popular ETF for the S&P 500 Index – is generally considered to represent “the market”.

Both the SPY itself and its options are some of the most liquid assets out there and are used by big funds to either make directional bets or hedge out their risks.

Therefore, the implied volatility on SPY’s options can be used to gauge the market’s sentiment – higher premiums will signal expectations of turbulent times ahead.

This is exactly what the VIX aims to accomplish.

The VIX is calculated using a complex math formula that’ll take a Ph.D. to explain….

 

Source: Quora

But in short, it comes down to something like this:

VIX aggregates weighted prices of SPY’s puts and calls across a variety of strike prices with over 23 but under 30 days until expiration.

The resulting value has historically averaged somewhere between 12 and 30, where 12 is considered low-volatility and 30 is high.

 

How Does it Move?

As I already explained, the value of VIX is based on the value of SPY options.

It’s not easy to affect the option prices of something as liquid as SPY, so if there’s a notable change in implied volatility – that really means there’s an influx of market participants on either side.

And they generally don’t massively rush into options when everything is well – it’s when things start looking scary that traders would pile in.

Therefore, VIX tends to read higher when the market drops and generally stays low when the market is in a regular bullish environment.

Have a look for yourself: here’s an overlap of S&P 500 with VIX:

 

Note the extreme levels the VIX may reach when the market truly freaks out – hence the “fear index” designation.

There Are Ways to Trade it

As with most market-related things, if something is popular, the Wall Street heads will figure out a way to trade it.

Same thing happened to VIX, which can currently be traded through a variety of products: the most notable ones are UVXY and VXX.

I’m not going to explain how it’s possible to trade a completely artificial indicator – that deserves an article of its own.

But I like to stay very cautious with VIX-related products – they may move very violently and are very unpredictable/unstable in nature.

 

What Is In It For Me?

Look, much like all other things – you can’t build out your entire trading premise around a particular number or chart.

But VIX is a very useful way to understand what the market is currently pricing in.

For myself, I like to have a glimpse at VIX a few times a day to get an idea of what “big money” thinks.

Quick moves and extreme readings may signal radical changes in the market character, but I’ll leave it up to you to decide what effect it may have on your portfolio.

Author:
Jason Bond

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