Interpretation
The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period. That is, index options are priced with the assumption of a 68% likelihood (one standard deviation) that the magnitude of the change in the S&P 500 in 30-days will be less than 4.33% (up or down).
The price of call and put options can be used to calculate implied volatility, because volatility is one of the factors used to calculate the value of these options. Higher (or lower) volatility of the underlying security makes an option more (or less) valuable, because there is a greater (or smaller) probability that the option will expire in the money (i.e., with a market value above zero). Thus, a higher option price implies greater volatility, other things being equal.
Even though the VIX is quoted as a percentage rather than a dollar amount there are a number of VIX-based derivative instruments in existence, including:
- VIX futures contracts, which began trading in 2004
- exchange-listed VIX options, which began trading in February 2006.
- VIX futures based exchange-traded notes and exchange-traded funds, such as:
- S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ) launched by Barclays iPath in February 2009.
- S&P 500 VIX ETF (LSE: VIXS) launched by Source UK Services in June 2010.
- VIX Short-Term Futures ETF (NYSE: VIXY) and VIX Mid-Term Futures ETF (NYSE: VIXM) launched by ProShares in January 2011.
Similar indices for bonds include the MOVE, LBPX indices.
Although the VIX is often called the "fear index", a high VIX is not necessarily bearish for stocks. Instead, the VIX is a measure of market perceived volatility in either direction, including to the upside. In practical terms, when investors anticipate large upside volatility, they are unwilling to sell upside call stock options unless they receive a large premium. Option buyers will be willing to pay such high premiums only if similarly anticipating a large upside move. The resulting aggregate of increases in upside stock option call prices raises the VIX just as does the aggregate growth in downside stock put option premiums that occurs when option buyers and sellers anticipate a likely sharp move to the downside. When the market is believed as likely to soar as to plummet, writing any option that will cost the writer in the event of a sudden large move in either direction may look equally risky.
Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. Only when investors perceive neither significant downside risk nor significant upside potential will the VIX be low.
The Black–Scholes formula uses a model of stock price dynamics to estimate how an option’s value depends on the volatility of the underlying assets.
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