Updated Mar 20, 2022

What is Chicago Board Options Exchange (CBOE) Volatility Index (VIX)?

What is the Volatility Index (VIX)?

The CBOE Volatility Index, abbreviated as the VIX, is a leading indicator of stock market volatility. The VIX volatility index reveals how financial professionals feel about short-term market circumstances. Knowing how well the VIX works and what it says can assist short-term traders fine-tune their portfolios and getting a sense of where the market is headed.

What Is the VIX?

The VIX, officially known as the Chicago Board Options Exchange (CBOE) Volatility Index, gauges the amount of volatility that professional investors believe the S&P 500 index will experience over the following 30 days. This is referred to by market professionals as "implied volatility"—implied because the VIX follows the options market, where traders make wagers on the future performance of various assets and market indices, such as the S&P 500.

People who follow the VIX index understand that the S&P 500 represents "the stock market" or "the market" as a whole. When the VIX index rises, it indicates that professional investors are reacting to increased price volatility in the S&P 500, in particular, and in markets in general. When the VIX falls, investors bet on smaller price swings up or down in the S&P 500, implying calmer markets and less uncertainty.

It's crucial to emphasize that, while volatility might have negative implications, such as more risk, increased stress, higher uncertainty, or larger market drops, volatility is a neutral phrase. It is merely a statistical measure of a security's or index's price fluctuations. Greater volatility indicates that an index or investment has larger price changes—either higher or lower—over shorter periods.

How Is Market Volatility Measured by the VIX?

The VIX index measures volatility by following S&P 500 options trading. Large institutional investors use S&P 500 options to position themselves as winners whether the market rises or falls, and the VIX index tracks these trades to evaluate market volatility.

The options market can be fairly opaque, but strictly speaking, the VIX gauges volatility by examining strike prices associated with various puts and calls based on options contracts expiring in one month as well as those expiring on different Fridays of the following month. Prices are weighted to indicate whether investors expect the S&P 500 index will gain or lose value in the short term.

In general, if the VIX index is 12 or lower, the market is regarded to be in a low volatility period. Atypically high volatility, on the other hand, is commonly defined as anything exceeding 20. When the VIX rises above 30, it is sometimes interpreted as a sign that markets are extremely volatile.

How to Invest in the VIX?

Investors can gain exposure to the VIX through a variety of products based on the CBOE Volatility Index. You can also buy and trade VIX options and futures contracts.

The simplest way to invest in the VIX is through exchange-traded funds (ETFs) and exchange-traded notes (ETNs) based on VIX futures. Because these instruments are exchange-traded, you may purchase and sell them just like stocks, considerably simplifying your VIX investing approach.

The ProShares VIX Short-Term Futures ETF (VIXY), which is built on VIX futures contracts with a 30-day maturity, is one of the most popular and accessible of these. Some exchange-traded funds (ETFs) allow you to bet on implied volatility up to six months in the future, such as the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), which invests in VIX futures with maturities ranging from four to seven months.

Before investing in any VIX exchange-traded instruments, you should be aware of some of the risks involved. Certain VIX-based ETNs and ETFs have lower liquidity than more commonly traded exchange-traded instruments. ETNs, for example, maybe less liquid and more difficult to trade, as well as with have higher fees.

Using the VIX to Make Investment Decisions

To keep on top of the market, market professionals rely on a wide range of data sources and tools. The VIX is a key indicator for determining when the market is about to make a significant move up or down, or when it is about to settle down after a period of volatility.

Through the prism of mean reversion, experts comprehend what the VIX is saying to them. Mean reversion is a basic notion in finance, implying that asset prices will generally remain near to their long-term averages. If prices rise dramatically in a short period or decrease dramatically in a short period, the principle of mean reversion predicts that they will soon return to their long-term average.

The VIX index tracks the S&P 500's tendency to deviate from and then return to the mean. When the stock market appears reasonably tranquil but the VIX index rises higher, professionals wager that the S&P 500—and thus the stock market as a whole—may be moving higher or lower in the near term. When the VIX falls, investors may interpret this as a sign that the index is reverting to the mean and that the period of higher volatility is coming to an end.

If you are an investor and you notice the VIX rising, this could be an indication of impending volatility. Consider transferring some of your portfolios to assets deemed less hazardous, such as bonds or money market funds. Alternatively, you might change your asset allocation to cash in recent profits and set away funds during a bear market.

When the VIX falls, indicating the likelihood of more stability in the stock market, it may make more sense to focus on individual companies or other riskier assets that may do well during periods of growth.

Always remember that there is no method to foresee future stock market performance or time the market when it comes to investing. The VIX is only a forecast, and it is wrong about market direction nearly as frequently as it has been right. As a result, most average investors are best served by investing in diversified, low-cost index funds regularly and using dollar-cost averaging to smooth out any pricing changes over time.