18 May 2022
The official name is the Cboe Volatility Index, although it is affectionately known as the VIX Index. Used by professional traders as a means of monitoring short-term volatility expectations on the S&P 500 index, it has proven very useful. Over the last 12 months, the VIX Index has been as low as 15, as high as 36.45 and currently stands at 32.56. So how is this useful to global traders?
Whether economic forecasts, interest rates, inflation or non-farm payroll numbers, what happens in the US impacts global markets. Therefore, many people use the VIX Index as a broad indicator of global markets. Initially, it began as a non-tradable volatility index, but there are now tradable derivatives based on the VIX Index.
We have also seen the introduction of additional niche VIX Indexes looking at specific areas of the market. However, for many people it is the original VIX Index which is most useful.
As the use of derivatives is widespread across the globe, you won’t be surprised to learn that the VIX Index is based on derivative prices. More specifically, S&P 500 index (SPX) derivative prices with near-term expiration dates. By monitoring the price of various call and put options, the index can forecast the expected volatility of the S&P 500 over the next 30 days.
Today the VIX Index is calculated using the weighted prices of a range of SPX calls and puts at different strike prices. As derivative markets are incredibly liquid and fast-moving, this ensures that the VIX Index can also be calculated in real-time. Volatility is often used to measure market sentiment, i.e. short-term concerns, which is a role that fits with the VIX Index structure. You will also hear the index referred to as the “Fear Index”.
Initially created back in 1993, the VIX Index focused on eight S&P 100 at the money put and call options. As derivatives markets weren't as liquid in 1993 as they are today, it was decided to focus on at the money options, which attract most trading activity. This filtered out illiquid and rarely traded out of the money options and provided a helpful market sentiment indicator by calculating expected volatility.
In 2003, following exponential growth in derivatives markets and trading volumes, it was decided to adjust the formula. The use of out of the money call and put option prices provides a broader representation of investor sentiment and short-term expectations.
Historically the VIX Index has been as low as nine and over 80, which indicated extreme volatility. As a rule of thumb, when the VIX Index is greater than 30, this suggests investor uncertainty, risk and a growing fear factor. Consequently, a figure of less than 20 would indicate relatively stress-free times ahead. However, as the index is calculated in real-time, it can quickly turn!
Such is the credibility given to the VIX Index; evidence suggests that the index figure is impacting option premiums and pricing. Considering that the VIX Index is calculated using option premiums and prices, this is an interesting development. Do we have a case of the tail wagging the dog?
Derivatives markets are useful for measuring investor confidence and expectations in the short term. Comparing and contrasting perceived fair option prices against actual option prices makes it possible to tap into overall market sentiment. Consequently, many professional traders will include the VIX Index in their investment strategy, not just for US investments.
Here at Global Investment Strategy UK, we appreciate that day traders tend to operate on relatively thin margins. Therefore our ongoing investment in new technology and competitive charging structure allows traders to maximise returns.
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If you would like further details on the VIX Index, you can visit the website at:-
https://www.cboe.com/tradable_products/vix/
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