The Cboe Volatility Index is generally referred to as the VIX, and it was originally created by the Chicago Board Options exchange (CBOE). It offers a gauge of the risk in the market at any given time and the prevailing sentiment of investors, by creating a real-time VIX index based on the volatility expected over the next 30 days. The VIX index is created on the basis of the price inputs of the S&P 500 index options.
Alternative names for the VIX
The VIX has also been known as the Fear Gauge and Fear Index, because it is used by the likes of portfolio managers, researchers and investors to ascertain factors like fear, stress, and risk within the market, and the levels they are running at before making any investment.
How the VIX Works
Where stocks are concerned the degree of volatility present refers to the variation in the trading price achieved over a set period of time. Two stocks in similar tech companies – Stock A and Stock B - may close on a specific date at prices of $105.29 and $104.89, making them broadly similar in value. Looking back at the way their prices had fluctuated over the previous month, however, reveals that within those 30 days the price of Stock A swung between highs and lows much more than that of Stock B. This indicates that Stock A was much more volatile for that particular month.
Drilling deeper into this example, however, might reveal that over the previous three months, rather than just one, it was Stock B that experienced the wider price swings, making this the more volatile stock over a longer time frame. By measuring price swings over a set period of time the VIX enables investors to build a picture of the volatility – and therefore risk – of individual stocks.
Alternative methods for measuring volatility
Two methods are used to ascertain the volatility of a stock or other financial instrument. The first, as detailed above, involves calculating on the basis of the price over a historical period. This method measures the average variance and standard deviation of price data sets from the past. The range of stock prices used can be entered into a program like MS Excel and the volatility calculated using the STDEVP() function.
The figure this method produces is called historical volatility and the standard approach is to take the volatility for the past three months, for example, and assume that the same pattern will follow over the next three months.
The other method uses option prices rather than the value of the stocks themselves. The price of options depends on the probability of a stock hitting a price known as the strike price or exercise price. For example, stock in Amazon might be trading at $252 per share. A call option on the stock has a strike price of $260 and one month to expire. The price of this option is clearly based on a perception of how much the stock will move within a month, which equates to the volatility of that stock. The fact that option prices are available on the open market means that they can be used as a tool to calculate the perceived volatility of the stock in question – in this case Amazon. Volatility calculated in this way is known as implied volatility as it looks forward to how much the price is expected to shift, rather than back to how much it already has shifted.
Utilizing VIX on a wider level
The same techniques outlined for calculating the volatility of a specific stock can be widened to calculate the volatility of a specific sector or an entire market. By observing the price shifts in an index such as the NASDAQ Bank Index, it is possible to take data relating to more than 300 stocks from the banking and financial services sector and use that data to assess the volatility of the sector as a whole. The same methods can be applied to an entire market, such as the S&P 500. In both cases, a combination of price fluctuations and option prices can be used to create a measure of volatility that looks both backwards and forwards in time.
The VIX index is forward-looking and based on the expected volatility of S&P 55 index options. As such, it represents the market expectation of volatility over the next 30-day period.
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