27
Apr

Investing in Volatility: Understanding the VIX

Written by Finance Magazine. Posted in Uncategorized

If you follow the stock market coverage on CNBC or Bloomberg, or read the Wall Street Journal, you’ve probably seen references to the VIX, especially in politically and economically volatile times like the 2008 financial crisis or last year’s election.

While it appears in charts and tickers like a stock or exchange-traded fund, the VIX itself is not an investment product. Calculated by the Chicago Board of Exchange (CBOE), the VIX Volatility IndeX is a measurement of the implied volatility across the options trading market — in other words, the higher the VIX, the more options are being bought at larger distances from a stock’s current share price.

The scale of the VIX is a prediction of how much the S&P 500 is likely to vary in the next year. So, for example, a relatively normal VIX of 20 means that at some point in the next year, the S&P 500 (and therefore its associated index fund, for the investor) is expected to touch a point either 20% above, or 20% below its current value as its furthest extreme. The lowest possible VIX, 0, would imply a completely flat market for an entire year, an unlikely occurrence as stocks rise and fall daily. The highest reasonable VIX, 100, would indicate that the market is reasonably confident in a total collapse within the next year — or an equally severe correction over a shorter period — and is an urgent signal to sell and short. (In the 1987 crash, the VIX actually spent a few days ABOVE 100, led by the Black Monday crash and a 23% daily drop in the S&P 500)

Theoretically, this measure of volatility would increase in both bull and bear markets, but the nature of the stock market is such that rising markets generally occur slowly and steadily, while selloffs happen in a series of one or more sudden crashes. Therefore, VIX tends to spike the highest when the market is is falling, making it seem at first sight to be a useful hedge.

But as we mentioned before, it isn’t possible to buy shares in the VIX. While many indices do have exchange-traded index funds, which are possible because a typical stock index is made up of a basket of shares of a known list of companies (and therefore, a fund invested in those companies in the same proportions, will move parallel with the index), the VIX is based on trading volume in the options market, and cannot easily be replicated with only equities.

It is possible, however, to invest in the VIX indirectly. CBOE offers VIX futures loosely based on the VIX, and options with the ability to put and call based on the value of the VIX futures. These alternative products do track volatility, but do not necessarily move in real time, except at the end of the month when the contracts expire, since they are traded based on market value, and are likely to lead the actual VIX based on investor sentiment. The delivery of the share occurs after the end of the month, when it will pay off at the fair value of the VIX index.

Another choice (although historically not a very good one) is to invest in one of the “VIX” ETFs on the market. However, these only approximate the VIX, and do so with portfolios of shorts and leveraged options, making them lose money in bull markets and only be viable for a quick return ahead of an expected drop in the stock market.

A more prudent usage of the VIX is in deciding whether to buy or sell, go long or short, or consider shifting into more conservative investments. When used as a guide, rather than an investment in and of itself, it can be a valuable metric to help understand investor sentiment in real time.

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