by Murray Green
The Chicago Board Options Exchange (CBOE) created its own indicator to predict volatility. It is called the VIX, which stands for “volatility index.”The number associated with the VIX is not its price; instead, the VIX is quoted in percentage terms. For example, if the VIX is at 20, it would indicate that the expected percentage change in the S&P 500 index over the next year would be between -20% and 20% with a 68% confidence level (one standard deviation). It is famously known as the “investor fear gauge” because it displays the total market risk. The VIX percentage value is calculated by taking a weighted average of option prices from the S&P 500 index. An option is when you pay a small fee to have the right to buy a stock within a certain time period at a previously agreed-upon price, but you are not forced to make the purchase. Simply, you have the option to buy it or not. The higher the buyers are willing to pay for an option, the higher they are expecting the stock market to rise or fall in the future. Thus, volatility increases along with the VIX. If the buyers are not willing to pay much for an option, it signifies that the buyer believes the market is in a more dormant state and the VIX slides as a result. The VIX is based off a credible index to show the real-time fear American’s have for the stock market because the S&P 500 consists of the top 500 valued stocks in the United States with a combined market cap of over 20 trillion dollars. However, the VIX does not have any ability to predict the future state of the market. In the days leading up to the stock crash of 2008, the VIX was at a 3 month low. This means the VIX predicted the lowest risk just moments before the crash. Just before the crash the VIX was at 18, which signifies an expected increase or decrease of 18 percent in the next year, but only 6 months later the S&P 500 had fallen 45.4%. The explanation for the VIX being unable to predict the future state of the market is because the VIX is calculated based on a collection of many buyer’s’ expectations for the future of the market. The VIX is nothing more than the consensus volatility of traders. Visually, it becomes clear that the VIX goes in the opposite direction of the S&P 500 index. This is ominous because the VIX reached its lowest level ever in late July at 8.84. The VIX is usually near its bottom right before a crash, as in 2007-2008. Nonetheless, the VIX remains a famous and heavily-utilized tool to gauge financial volatility in uncertain times. Terms:
Option: “A stock option is a privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) a stock at an agreed-upon price within a certain period of time.” Index: “A market index is an aggregate value produced by combining several stocks or other investment vehicles together” Premiums: “An option premium is the income received by an investor who sells or "writes" an option contract to another party.” S&P500: “The Standard & Poor's 500 Index (S&P 500) is an index of 500 stocks seen as a leading indicator of U.S. equities and a reflection of the performance of the large cap universe, made up of companies selected by economists.”
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