Beginners Guide to VIX or Volatility Indices

Stock investors and traders look for every subtle sign that can help them predict the future movements of stock prices. VIX and other volatility indices can help investors gauge market sentiment and capitalize on changes to volatility. 

What is Trading Volatility?

Trading volatility refers to the sharpness of stock price movements. Volatility functions like a wave. Low volatility in the stock market is similar to a calm wave. There isn’t much movement, and a stock worth $50 per share may fluctuate between $49.75 per share and $50.25 per share. 

High volatility is similar to a stormy sea with larger waves. An investor can realize more gains during high volatility, but those gains can quickly turn into losses. In an extreme scenario, a stock can swing from $50 per share to $45 per share or $55 per share within a week. 

Volatility does not mean a stock trades up or down. A stock can still exhibit sideways movement over several days of high volatility. A stock that goes from $50 to $70 and then back to $50 within a trading week has high volatility, even though shares closed flat. 

What is the CBOE Volatility Index (VIX)?

The CBOE Volatility Index is a popular index that investors and traders use to gauge volatility. VIX’s value comes from short-term SPX options and can help investors forecast future changes to volatility. 

How Does the CBOE Volatility Index Work?

The CBOE Volatility Index isn’t enough for an investor to assess how stocks will move in the upcoming days, weeks and months. Investors also have to look at the movement of another index, such as the S&P 500 or Nasdaq 100, to predict how stock prices will move. Since the CBOE Volatility Index focuses on options that track the S&P 500, it is a better measure of the S&P 500’s volatility. However, the S&P 500 and Nasdaq 100 share many similarities in their Top 10 holdings. Investors use this metric to gauge the level of risk and how market participants are feeling about the overall market.

How to Calculate VIX Value

The VIX calculation depends on which options you select. You will have to start the calculation by selecting calls and puts with back-to-back expiration dates. Investors should target calls and puts that expire in roughly 30 days. Summing up the contributions for each option toward total variance will reveal the total variances for both expiration dates. Interpolating the two variances will lead to the 30-day variance. Then, you can take the square root of that number and multiply it by 100 to arrive at the VIX index value.

Benefits of Using Volatility Indices

Volatility indexes offer several advantages for investors and traders. These are some of the perks you can expect.

• Identifying market sentiment: Knowing market sentiment can help you position your portfolio to benefit from the current trend. You can increase the probability of making successful trades by being aware of how investors feel about the stock market. 
• Forecasting market volatility: Tracking market volatility can help you adjust trades based on your risk tolerance and other factors. You can also make trades that benefit from high or low volatility, depending on what the VIX indicates.
• Hedging against market downturns: VIX tends to gain value quickly during volatile market downturns. The gains from a volatility index like VIX can help offset some of your losses.

Types of Volatility Indices

VIX is the most popular volatility index, but investors and traders have several choices. These are some of the volatility indices to consider.

• VIX Futures: These futures allow investors to trade assets that revolve around VIX movements. These futures gain value when stocks fall, and investors become nervous. 
• VIX Two-Month: The VIX Two-Month Index uses SPX options that expire in two months to gauge volatility.
• Cboe VIX Tail Hedge Index: This index mirrors the returns of holding onto the S&P 500 index and buying VIX calls. The weight of VIX calls compared to S&P 500 index holdings varies based on market conditions.
• VXN (Nasdaq 100 Volatility Index): This volatility index focuses on the Nasdaq 100 and helps investors measure its potential volatility. It is similar to VIX.
• RVX (Russell 2000 Volatility Index): This volatility index is similar to VIX, but it focuses on the volatility of the Russell 2000.

How to Trade the VIX

You can trade the VIX just like trading a stock or option. You can enter VIX as the ticker and initiate buy and sell orders. Many brokerage firms have created exchange-traded funds (ETFs) that track the VIX, so it is easier to manage. These are two ETFs that give investors exposure to the VIX:

• ProShares VIX MidTerm Futures ETF (BATS: VIXM)
• ProShares Short VIX Short-Term Futures ETF (BATS: SVXY)

There is some lag with how VIX ETFs perform compared to the VIX itself. ETFs that track the VIX also have higher expense ratios than other ETFs that hover close to 1%.

Important Factors that Affect Volatility Indices

Several market factors impact volatility indices. These are some of the factors to monitor:

• Economic events: Updates to employment rates, GDP, inflation, and other economic indicators can impact volatility.
• New releases: Any new information can lead to changes in volatility.
• Political developments: Rising tensions can lead to sharper volatility, while resolutions can minimize volatility.
• Market sentiment: The way investors feel about the market impacts their decisions.
• Investor behavior: Any dramatic swing to greed or fear can stir up additional volatility.

Navigating Market Volatility

Volatility indices help investors gauge volatility and predict how stock prices will change. Volatility is an important component of the stock market that can impact your total returns. Indicators like the VIX can leave you better prepared for what’s to come and hedge against market downturns.

Frequently Asked Questions