Understanding the Volatility Index (VIX)
“The market is highly volatile at this point”
You have frequently heard the term volatility mentioned in various market discussions and always wondered “How does one even know ??”
Did you know that just like the S&P 500 or NIFTY or NASDAQ, there was also an index mapping the volatility? Introducing the Volatility Index or VIX, sometimes also misrepresented as the “Fear Index”.
What is it ?
The VIX provides the “expectation” of market volatility over a 30 day period. It is calculated based on the option premiums for its benchmark index. For example, the VIX in the United States represents the volatility based on the premiums of calls and puts in the S&P 500 index. If you reside in India, the VIX is based on the NIFTY index, deriving its expectation of volatility based on the option premiums for the respective index.
As always let’s avoid the technical aspects and understand how this can be used for making our investment decisions.
Any premium on options can be considered as the risk associated with the market. You are all aware of the concept of high-risk-high-returns, thus a high premium option can be associated with high risk. Low premiums imply lower risk. The VIX is therefore computed using a weighted average of all the option prices on a particular index, resulting in a single number represented as VIX.
Generally speaking, the VIX provides an idea of how much investors are paying to purchase the right to buy or sell on an index.
Let us look at the plot of the VIX below :
In the year 2008, the VIX showed a value of 59.89! What does this mean? Based on the option premiums on the S&P 500, the S&P was expected to move up(+) or down(–) by 59.89%, 68% of the time(represents one standard deviation). Understand the mathematics of Market Volatility. Without getting overwhelmed with the mathematics of it, this number (59.89) indicates a state of high volatility. We know the year 2008 was when the big recession wiped out the S&P 500 by more than 50%, and the VIX was also appropriately indicating the fear in the market.
Historically, a VIX below 20 indicates a low risk market environment. However, an extremely low VIX indicates complacency, meaning everyone is bullish. When the VIX goes beyond 20, fear is starting to enter the market, indicating a high risk environment. We can see from the graph that the current level of VIX stands at 12.86 indicating the S&P is expected to be in a range of ±12.86%.
Is VIX the Best Market Valuation Indicator ?
Although the VIX is based on the weighted average of option prices, it is more a representation of our inability to understand risk and the price of the unknown. We have covered some other market indicators in another post Is the Market Overvalued or Undervalued?, and just like any indicator, this too is riddled with flaws due to human perception. The market is often derived from human greed and fear as opposed to mathematical models and fundamentals.
So How Can I Use the VIX ?
As investors, it is important to have complete information and knowledge of these type of indicators. The VIX is certainly a helpful indicator providing an accurate measure of the premiums associated with options trading on an index. Here are 3 important things the VIX is NOT:
A low VIX does NOT mean it the right time to buy
A high VIX does NOT mean it is time to sell everything you own
VIX is NOT a forecasting tool
And it IS…
It IS driven by buyers and sellers, thereby implying the significance of the forces of greed and fear. As investors we can gauge the overall market mathematically, using such indicators, but it is more important to determine the human sentiment driving it. As I have often stated “Anybody who claims the ability to time the market, is a LIAR”, similarly the VIX is not your tool to time the market.
If you also wish to learn how to trade the VIX, you may find this article useful: 4 Ways To Trade The VIX
I hope this post has been useful in understanding the various elements of the stock market we sometimes tend to overlook. Feel free to share your thoughts and ideas so we can keep learning and progressing each day!
Be Frugal, Be Smart, Be Rich!