Investors get used to market volatility over time. There’s always something that can shake up a company, sector or even the entire market. But what if you could measure that volatility, to quantify the level of disruption present within markets? That’s exactly what VIX intends to do. 

The ticker symbol for the Chicago Board Options Exchange’s (CBOE) Volatility Index, VIX is a weighted mix of the prices for a blend of S&P 500 Index options, from which the index derives implied volatility. Many investors see it as the inverse of the market. When it trends higher, it usually means the market is falling under volatile conditions. Conversely, the lower VIX is, the stabler prices generally are. 

For many investors, it’s less an investment vehicle and more of a “canary in a coal mine.” Learn what this index tells investors and how VIX activity can shape market events. 

How Does VIX Work?

Volatility is the measure of price fluctuations over a certain period of time. It’s calculated by looking at the historic price movements of a company and factoring in variables such as mean, variance and standard deviation. Applying them to a stock’s historical price performance allows investors to make conclusions about how volatile the stock is and what might constitute volatile behavior in the future. 

Over the past 12 weeks, ABC Company has experienced a mean growth rate of 12%, with variance of only 1-2% per month and a standard deviation of 0.5% each day. These tight figures suggest that the company is relatively stable, with very little volatility. If the company starts to see daily price swings of 1.5% and shows higher and lower swings month over month, it’s a sign of increasing volatility. 

VIX works by extrapolating volatility data for a blend of S&P 500 companies, then using S&P 500 index options (SPX) to look ahead at investor confidence. To maintain a consistent look ahead at volatility, it only considers SPX options with an expiry period of 23 days to 37 days ahead. By taking these figures and running them through an incredibly complex formula, the CBOE calculates the expected volatility of the market looking ~30 days into the future. 

The History of VIX as an Index

The CBOE created VIX in 1992, after years of researching volatility trends dating back to 1986. Using data gleaned from the market’s performance, as well as forward-looking options contracts, CBOE researchers calculated the first iteration of VIX, successfully quantifying volatility. 

In 2003, the CBOE updated the VIX formula to reflect new computations for volatility. The old formula, dubbed VXO, phased out. Since this change, it has become the de-facto method for measuring volatility. As if to illustrate this point, the index spiked to a record intraday high on October 24, 2008 ($89.53) signaling a full-blown financial crisis (The Great Recession). More recently, VIX reached an all-time daily high of $82.69 on March 16, 2020, at the peak of the COVID-19 pandemic. 

Trading vs. Tracking

As an index, it’s possible to trade VIX—and many investors do. More investors choose to track it, however. In either capacity, it’s a useful investment resource. 

Trading the VIX

Investors who trade VIX do so to capitalize on volatility. A direct investment is roughly equivalent to a short position—a bet that the market will struggle in the near term. More often, however, investors use it to hedge. For example, if you plan to hold an S&P 500 ETF long-term but want to hedge against short-term volatility, trading VIX can neutralize short-term losses. Finally, investors can short VIX, which is effectively akin to assuming the market will push higher. 

Tracking the VIX

For those who track the VIX, it represents an important tool for trading with (and against) volatility. Specifically, traders look at a stock’s beta value against the implied volatility of VIX. A company’s beta represents volatility with respect to the move in a broader market index. A beta above 1 means the stock will fluctuate more than the market; below 1 signals relative stability from the stock against market movements. Traders often look for high-beta companies vs. VIX to capitalize on price swings. 

Other Volatility Indices to Consider

The popularity and utility of the VIX is well-proven, and they’ve led to the formation of several other volatility indices. Some of the following are also inventions of the CBOE; others are private funds. 

• ProShares VIX Short-Term Futures ETF (VIXY)
• iPath Series B S&P 500 VIX Short Term Futures ETN (VXXB)
• VelocityShares Daily Long VIX Short-Term ETN (VIIX)

There are dozens of index funds and ETFs that track broad market volatility, as well as many sector-specific products. They all function relatively the same: by looking at futures to assess and apply investor sentiment in the form of expected volatility. Investors can use them as increasingly accurate benchmarks for evaluating sectors or the indices they track. 

A 30-Day Peek into the Future of Volatility

Every investor wishes they had a crystal ball, to look into the future. While VIX might not tell you exactly which stocks to choose, it can shed light on upcoming volatility and turbulence—or lack thereof. Whether you trade or use it as a tool to track other investments, its purpose as a shadow of the S&P 500’s volatility makes it a useful resource for any investor to capitalize on.

And its a great tool in recognizing trends for investors of all experience levels. To learn more, sign up for the Profit Trends e-letter below.

If VIX is humming along as a stable level, you’ve got nothing to worry about. If it’s on the rise and getting higher, there are likely turbulent times ahead. Act accordingly and let it be your compass.