Tracking Volatility With the VIX

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Tracking Volatility With the VIX

Financial websites, bloggers, social media, newspapers, and television analysts all allude to the VIX when market volatility increases or pauses. The VIX, formally known as the Cboe Volatility Index, is a benchmark index established primarily to measure the volatility of the S&P 500. Because the VIX has become a proxy for market volatility, most investors who are acquainted with it refer to it as the “fear gauge.”

The VIX was developed by Cboe Global Markets (Cboe), formerly known as the Chicago Board Options Exchange, which describes itself as “the biggest US options exchange and developer of listed options.”

The Cboe operates a for-profit firm that sells assets to sophisticated investors, among other things. Hedge funds, professional money managers, and individuals that make investments in order to benefit on market volatility are examples of this. The Cboe created the VIX, which measures market volatility in real time, to enable and promote these investments.

While the arithmetic underlying the computation and the accompanying explanation take up the majority of a 15-page white paper produced by the Cboe, we’ll present a summary of the highlights. Here’s a peek at the VIX’s computations, courtesy of examples and data given by the Cboe.

Key Takeaways

  • The VIX is a benchmark index meant to monitor the volatility of the S&P 500.
  • The VIX is derived by averaging the weighted prices of out-of-the-money options and calls to gauge projected volatility.
  • Volatility is beneficial to investors since it allows them to analyze the market situation and presents investing possibilities.

A Look at the VIXfor the Mildly Curious

As an illustration of how the VIX is computed, the Cboe gives the following formula:

Delving Into the Details of the Volatility Index

The VIX is computed using a “formula to determine predicted volatility by averaging out-of-the-money option and call prices.” In the example below, we will begin on the far left of the formula with options that expire in 16 and 44 days, respectively. The symbol to the left of “=” signifies the number obtained by multiplying the square root of the sum of all the numbers to the right by 100.

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To get to that number:

  1. Time is represented by the first set of digits to the right of the “=”. This value is calculated by dividing the time to expiry in minutes of the closest term option by 525,600, the number of minutes in a 365-day year. The time to expire in minutes for the 16-day option will be the amount of minutes between 8:30 a.m. today and 8:30 a.m. on the settlement day, assuming the VIX calculation time is 8:30 a.m. Until put it another way, the period to expiry excludes midnight to 8:30 a.m. today and 8:30 a.m. to midnight on the settlement day (full 24 hours excluded).Technically, we’ll have 15 days to deal with (16 days minus 24 hours), thus 15 days x 24 hours x 60 minutes = 21,600. Until calculate the time to expiry in minutes for the 44-day option, multiply 43 days by 24 hours by 60 minutes = 61,920. (Step 4).
  2. The result is multiplied by the option’s volatility, which in this case is 0.066472.
  3. The result is then multiplied by the difference between the number of minutes before the next term option expires (61,920) and the number of minutes in 30 days (43,200).This result is divided by the difference between the number of minutes until the next term option expires (61,920) and the number of minutes before the near term option expires (21,600).If you’re wondering where the 30 days comes from, the VIX is based on a weighted average of options with a constant maturity of 30 days to expiry.
  4. The result is added to the total of the second option’s time computation, which is 61,920 divided by the number of minutes in a 365-day year (525,600).As with the initial calculation, the result is multiplied by the volatility of the option, which in this case is 0.063667.
  5. Then, we repeat the procedure described in step 3, increasing the result of step 4 by the difference between the number of minutes in 30 days (43,200) and the number of minutes before the near-term options expire (21,600).We divide this result by the difference in the number of minutes before the next-term option expires (61,920) minus the number of minutes until the near-term options expire (61,920). (21,600).
  6. The total of all preceding computations is then multiplied by the result of dividing the number of minutes in a 365-day year (525,600) by the number of minutes in 30 days (43,200).
  7. The VIX is equal to the square root of that value multiplied by 100.
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Clearly, the sequence of operations is essential in the computation, and most of us wouldn’t want to spend a Saturday afternoon calculating the VIX. And if we did, the workout would undoubtedly take up the most of the day.

You’ll never have to compute the VIX since the Cboe Volatility Index does it for you. You can go online, key in the ticker VIX, and have the number shown on your screen in a moment, thanks to the Internet.

Investing in Volatility

Investors benefit from volatility because it allows them to evaluate the market situation. It also presents prospects for investment. Volatility investments may be used to hedge risk since volatility is often linked with poor stock market performance. Of course, volatility may also be associated with fast rising markets. Volatility investments may be utilized to bet whether the direction is up or down.

Investment instruments utilized for this purpose, as one would think, may be rather sophisticated. VIX options and futures are attractive tools for skilled traders to put hedges or execute their hunches. These are often used by professional investors.

Exchange-traded notes (ETNs) are another sort of unsecured, unsubordinated debt product that may be employed. The iPath S&P 500 VIX Short-Term Futures (VXX) and iPath Series B S&P 500 VIX Mid-Term Futures (VXX) are two volatility-tracking ETNs (VXZ).

For many investors, exchange-traded funds are a more familiar vehicle. ProShares Ultra VIX Short-Term Futures (UVXY) and ProShares VIX Mid-Term Futures (UVXM) are two volatility ETFs to consider (VIXM).

Each of these investment vehicles has advantages and disadvantages that should be carefully considered before making an investing choice.

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The Bottom Line

Investing in volatility, regardless of the aim (hedging or speculating) or the exact investment vehicles selected, is not something to leap into without first learning about the market, the investment vehicles, and the range of potential outcomes. Making a mathematical mistake in your VIX calculation may have a greater impact on your own bottom line than failing to perform thorough planning and investing prudently.

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