The CBOE Volatility Index is one of the most popular gauges of volatility in the financial markets. It is a real-time index that is derived from the price of SPX options with near-term expiration dates which creates a 30-day projection of expected volatility on the S&P 500. It is also known as the fear index for its ability to highlight investors sentiment. Given the S&P 500’s importance as a leading US stock market indicator and a globally renowned Index, the expected volatility on it could easily affect other indices around the world.
Aside from being an index, the VIX is tradable through futures, options and ETFs, for those who are looking to speculate on volatility directly.
Putting it simply, the VIX (Figure 1) moves up when markets are falling and will move lower and settle if the market is rising. While it can get to very low prices, it will never go to zero given the evergreen volatility that exists on options. In the example below, the VIX (candles) is overlaid with the S&P 500 e-mini futures (orange).
Figure 1 – VIX versus S&P 500 futures
The VIX is a great tool for those who have portfolios and are concerned with potential future volatility. In other words, if the market has been steadily rising and the VIX is declining and flattening, at one point, market conditions may become too quiet and could hint at a potential surge in volatility. This is ideally where portfolio managers will begin to obtain risk mitigation products such as options and they will do so quickly before volatility jumps and they become too expensive.
Another way of looking at volatility is finding potential reversals after a bout of above-average volatility and considering entering into long positions on the S&P 500 and other indices while keeping in mind that volatility could jump again and indices could continue lower.
It’s important to be mindful of current VIX readings. Remember that a flattening VIX will not last forever and at the same time, a surging VIX will not hold those prices forever, given no other variables come in. During times of uncertainty, volatility could be above-average for extended periods of time.
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