Jon Lewis

Understanding the VIX and Using it to Your Advantage

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We often mention the CBOE Volatility Index (VIX) as one of our market sentiment gauges. The VIX is often referred to as a "fear index," but what exactly is the VIX, and how does it measure fear?

Today I'll give you a basic understanding of what the VIX is and how we use it.

I'll start off by saying that there are some rather complex calculations underlying the derivation of the VIX. In fact, the Chicago Board Options Exchange (CBOE) devotes no less than six pages in a white paper to describe the calculation. Don't worry, though, I won't go into that much detail. (Frankly, I don't understand it, nor do I care to.)

What is the VIX?

Introduced by the CBOE in 1993, the VIX is a measure of the market's expectation for volatility during the next 30 calendar days. It is calculated from S&P 500 Index (SPX) option prices, and is continuously updated throughout each trading day. Both call and put options are used in the calculation.

Option prices are based on a number of factors, including an expectation of future volatility of the underlying stock or index. The more volatile the market expects the underlying to be during the life of the option, the higher the option's premium. Thus, SPX option prices reflect future expected overall market volatility.

Volatility tends to rise when investors are nervous about the future, especially during market weakness (such as the bottom in October 2008). Option prices (usually put options) tend to rise when investors seek either protection for their holdings or to speculate on a downside move. Thus, in times of overall market stress, SPX option prices -- and the VIX -- tend to rise. That's why the VIX is considered a measure of fear.