In my opinion there is no more widely referenced yet more broadly misunderstood financial product than the CBOE Volatility Index, also just known as the VIX.
Next time you’re chatting about volatility at the water cooler at work or somebody brings up the VIX at a dinner party (I don’t go to parties much, do people do that?) but ask them:
What is the VIX? What does the number actually mean?
What you may find is that as cool and sophisticated as it may make the person sound to talk about, they rarely actually know what it is or what it means. So it’s my intention today to make you the most interesting person at your next dinner party by being able to explain the simplicity of what the VIX index actually is.
Simply put, the VIX index measures within one standard deviation confidence level, the forward one year expected range of movement of the S&P 500.
That’s it. For all it’s mention on financial networks, blogs, Twitter, that’s all it really is. It’s calculated based on S&P 500 option prices so it’s a statistic that measures the expected forward movement of the stock market.
Now it does have a few broader implications and it is part of the chain of derivatives of derivatives within the volatility landscape, but at it’s core it’s really quite simple.
Example) Yesterday the VIX index closed at 20.24. Now this isn’t a price like most other financial products are quoted in, it’s actually a percentage.
So more specifically, the VIX index closed yesterday at 20.24%
Based on S&P 500 options activity, market participants are pricing in within one standard deviation confidence that the S&P 500 will move within a range of 20.24% over the next one year. Remember from yesterdays blog which you can see again here, the VIX index is non-directional, it’s magnitude only. So within a range of up or down 20.24% over the next one year is expected right now.
But we can take this a step further and actually turn the measurement into different time periods.
– If you want to know what magnitude of S&P 500 movement market participants are pricing in for the next one month, just divide the VIX index by the square root of 12 (3.46)
20.24 / 3.46 = 5.85%
Within a range of 5.85% up or down over the next one month.
– If you want to know the S&P 500 expected movement over the next one week, divide by the square root of 52 (7.21)
20.24 / 7.21 = Within 2.81% over the next week.
– What about just one trading day? Divide by the square root of 252 (15.87)
20.24 / 15.87 = Within 1.28% over the next day.
And as we’ve seen in the last couple months, daily moves of 1.28% are happening all the time so this is why the VIX index right now is at 20.24. It’s because it’s justified. The VIX index will only go down to the lower teens when the S&P 500 stops getting trashed around from day to day.
So that’s it, you’re ready to impress all your friends with what that VIX index value actually means. I’ll leave you with a table that you can just get a ballpark for the expected forward movement over the most common time periods.
FYI since 1990, VIX closes ranged from 9.14 to 80.86
If you’re interested in finding out how I use the VIX and other Volatility metrics in my investing, please sign up for my VTS Newsletter for a free 1 month trial to all my trading strategies and blog articles.
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