VIX, fully known as The CBOE Volatility Index, was created by the Chicago Board Options Exchange in 1993. It was an Index obtained by calculating the weighted average of implied volatility based on the option price of S&P100*, one of the three major US stock indexes at that time. The VIX is also known as the “fear index” or “fear gauge” because it measures market sentiment and estimated risk. Here’s how the VIX relates to the performance of U.S. stocks and what it can do for investors.

*S&P100 changed its name to S&P500 (the Standard & Poor’s 500 Index) in 2003

Why VIX is also called the Fear index?

VIX takes as the market price of the S&P 500 index options*, that is, the call and put option prices of the S&P500 in the near term and the next month, and is used to predict the market volatility in the next 30 days.

* An option is a fixed-term contract in which the buyer has the right to buy or sell the underlying asset at a predetermined price at a predetermined point in time. Thus, the rise and fall in the price of options indicate how much investors are willing to pay to hedge their exposure to the underlying asset, which can be used to analyze the market conditions.

Below is the formula of VIX:

VIX (CBOE Volatility Index): How it Predicts Market Volatility

Since its calculation method is very complex, we will not discuss it here. Rather, it is more important to understand the reasons why VIX runs counter to the S&P500 index.

VIX can represent the majority of investors’ views on the future market trend and can be used to predict the changes in market trends.

Therefore, when VIX rises, it means that the market volatility will increase in the future and there may be uncertainties in the stock market. When VIX declines, it means that the volatility has reduced and there won’t be large movements in the stock market in the near term

Significance of VIX

There are several key values of VIX that investors need to keep an eye on::

When the VIX is below 20, it indicates that investors are optimistic about the future of the stock market and believe that the subsequent market trend is relatively stable, which will not have a significant impact on their positions.
When the VIX is above 30, it indicates that investors are pessimistic about the future of the stock market and believe that there will be large fluctuations in the market in the near term, and their positions may be affected.

Under extreme circumstances, the VIX may skyrocket or drop sharply, such as panic selling during the stock market crash, or market chasing in a frenzied buying boom. In these two extremes and unilateral moves, investors should pay special attention to the values of 15 and 40

When the VIX is below 15, investors are optimistic about the future of the stock market, and the market is full of optimism. In this bull market, stock prices are rising, but the rational investor needs to be aware that this might be false prosperity and the market may be about to reverse.
When the VIX is above 40, it means that investors are pessimistic about the future of the stock market, and the market is full of pessimism. In this bear market, stock prices continue to fall, but smart investors should know that this could be driven by irrational fear and that the market may rebound soon.

What is the relationship between the S&P 500 index and VIX?

When the VIX is high, it means that investors are uneasy about the future of the S&P500. Conversely, the lower the VIX, the more secure investors are about the future of the S&P500. Therefore, in a bear market, VIX tends to rise; In a bullish environment, the VIX will fall or stay stable, because it is calculated based on implied volatility, and the long-term bullish S&P500 has low implied volatility.

What is the relationship between the S&P 500 index and VIX?

It can also be understood that when the S&P500 index falls, investors’ demand for options will be strong. In order to protect the positions held, the bulls will buy put options for their portfolios, which will increase the implied volatility and the VIX. On the contrary, when the S&P500 index rises, the demand for options will decline, and the implied volatility and VIX will also decrease.

Bullish investors buy put options for their portfolios in order to protect their positions, which makes implied volatility and VIX index rise. On the contrary, when the S&P500 index goes up, the demand for options will be sluggish, and the implied volatility and VIX index will also decline.

Figure 1: Correlation between the S&P 500 and the VIX

It can be seen from the figure that the S&P500 index and the VIX index goes in the opposite direction, and there is a strong negative correlation between the two. According to statistics, the negative correlation between the S&P500 index and the VIX averages -80% and ranges from -70% to -90%. This means that when the stock market falls, the VIX will rise, and when the stock market rises, the VIX index will fall.

Use of VIX for investors

The VIX can be used to predict future market trends because it is a leading indicator of the market, which is contrary to the real market volatility calculated based on the historical price. The VIX is derived from the amount investors are willing to pay to hedge their positions after buying and selling stocks (option is used when anticipating a sharp rise or fall in the stock price). Therefore, the VIX is a reflection of the market sentiment for investors, and can also be used as a leading indicator to judge the future market. Of course, the VIX can’t accurately predict the direction of the market, but it can reflect the current market atmosphere, so investors can make appropriate risk management, such as reducing positions or even closing out positions.

Generally, when the market falls sharply, investors will quickly buy put options to hedge the risk and push up the VIX, which often makes the index peak within a short period of time. It could also be a leading signal as to whether investors are being overly pessimistic and overreacting to stocks at the moment. In most cases, indexes can’t stay high for long, that is, the market may eventually rebound, which means investors can refer to the rise and fall of VIX to find a bottom to enter the market during a market panic.

The VIX, now a measure of market volatility, has become a tradable asset after 2004. In recent years, many derivatives linked to the VIX index have emerged, allowing investors to trade the VIX. Consequently, the VIX has become more volatile because it can be traded, which also makes the forecast of the stock market less accurate (for example, the VIX calls directly into the market rather than buying options). However, the VIX still has some reference value for predicting the general direction of the market.

——

About ZFX (Zeal Capital Market)

The Best Trading Platform Award 2019 from Financial Weekly, Regulated by FCA & FSA.
100+ trading assets, including Forex, Stocks, Indices, Gold, Crude Oil, etc.
3 types of trading accounts to meet the needs of every customer
0 commission, low spread, leverage ratio up to 1:2000
Powerful trading platform that executes 50,000 orders/s
Open an account with a minimum deposit of $50
24-hour Customer Service

——

Risk Warning: The above content is for reference only and does not represent ZFX’s position. ZFX does not assume any form of loss caused by any trading operations conducted by this article. Please be firm in your thinking and do the corresponding risk control.

Knowledge is POWER

Never miss an opportunity to learn and grow as a trader. Join the ZFX Academy mailing list to be the first to know about our next webinar, article or guide.