What is the VIX Index and how does it influence the investor’s behaviour in the stock market
The VIX index is a widely referenced measure of US stock market volatility. It is produced by the Chicago Board Options Exchange (“CBOE”), who use the S&P 500 stock index as a rough indication of the “US stock market”.
It has become widely referenced because it is so easily available (a simple google search will find the latest level), and serves well as a quick check on how investors are currently feeling about the US stock market.
So if investors / traders become super uncertain about the future, that will lead to a higher VIX level – have a look at how it moves next time you see an episode of crazy Trump tweets or the latest fallout in the trade war drama!
During periods of heightened volatility, some traders go “hunting” for opportunities – stocks which might be trading much lower for no obvious reason other than the market panicking could be smart investments, while stocks which are trading much higher for no obvious reason than the market looking to buy “safe” investments could present a good selling opportunity.
How do we interpret it?
As an example, if you see the VIX index at 20%, that can be read in (somewhat) plain English as “there is a roughly 68% chance that the S&P 500 index will move 20% higher or lower in the next year”.
But what about Europe?
Well, we have one too – it’s called the VSTOXX index, and is interpreted similarly to the VIX index. It hasn’t become as widely referenced, however, because it uses Europe’s 50 biggest companies to calculate volatility (part of the Euro Stoxx 50) – obviously not as broad as the 500 companies included in the VIX calculation!
How is it calculated? (Warning: boring technical stuff coming up)
There are two parts to the VIX index, the expected volatility of the S&P500 stock index over the next 30 days and the expected yearly figure that’s based on the monthly figure – go figure!
The monthly figure is calculated by looking at the mid-prices (the price between the highest price and lowest price) of 30-day put and call options for the S&P500 index. This mid-price takes into account the bid/ask spread (so what investors are buying and selling for).
They then reverse-engineer the implied volatility that’s expected by the whole market, based on these observed mid-prices.
This implied volatility is represented as an estimation within one standard deviation i.e. with a c. 68% confidence interval (a 68% confidence interval – or one standard deviation – means there is roughly a 68% chance that the estimated implied volatility will be correct, and a 32% chance that it could be higher or lower than what has been estimated) – this is where “there is roughly a 68% chance…” comes from in our above interpretation).
The VIX Index itself is then created by taking this monthly implied volatility and translating it into a yearly output (in our above interpretation, this is where the “…will move 20% higher or lower in the next year” comes from).