As beginners learning how and where to invest money in Singapore, you may have been hearing much about the VIX lately. The VIX is shorthand for the volatility index. It is often dubbed the fear index. This is because when the VIX increases, the S&P 500 tend to decrease. In this post we will be looking at what the VIX is and why it has that special relationship with the S&P 500.
What is the VIX
To learn more about the VIX, its important to know what it is a yardstick for. The VIX measures the amount of expected volatility in the S&P 500 index in subsequent 30 days. This is achieved by calculating implied volatility of option prices for companies that are included in the S&P 500. In calculating the VIX, CBOE aggregates all the eligible options to create an at the money option with a 30 day expiry and measures the implied volatility of the instrument.
Inverse relationship between VIX and S&P 500
There are many who ask about the relationship between VIX and S&P 500. Why is it that when S&P 500 is down, the VIX often goes higher. The reason is because the participants in the options markets do react to the perceived uncertainty in the S&P 500. When the market is uncertain about price movement, option traders tend to buy and drive up the prices of puts. This then translates to higher implied volatility for the entire S&P 500.
How to interpret the VIX
The VIX is calculated as an Annualised Figure. When the VIX is at 40, what it implies is that market is pricing in an expectation that the S&P 500 will increase or decrease by 40% within the year. When the VIX is quoted at 20, this can be interpreted as SPX options pricing in an annualised move, up or down, of 20 percent in the S&P 500 index over the next 30 days. To adjust for monthly or daily ranges, one will have to divide the annualised figure by either a square root of 12 or square root of 252.
However, it is important to understand that the square root rule is only a rule of thumb and only helps to describe the relationship between volatility and time in a typical ‘brownian motion’. In times of excessive volatility this relationship does not hold. As such, the use of the VIX in calculating expected risk will not be very reliable in such periods.
This is by far not an exhaustive explanation of what the VIX is. However, it does serve as a good introduction for those who want to understand more about this particular instrument.