VIX Index guide – learn how to use the volatility index

The VIX Index, originally known as the “Volatility Index,” was created by the Chicago Board Options Exchange (CBOE) in 1993. Its purpose is to gauge short-term market volatility expectations. Volatility measures how uncertain a market is.

Per se, volatility does not indicate risk – risk is defined as the chance of an investment going down. On the other hand, volatility refers to changes both up and down – hence, an asset with high volatility could mean that it can enjoy a sharp price increase, which is seen as a positive aspect for investments.

VIX Index: What is it and how to use it?

The VIX Index is often referred to as the “fear index” because it helps traders grasp market sentiment, which can swing between fear and optimism. Essentially, it’s a mathematical tool used by investors and financial experts to analyse and compare market characteristics. Among volatility indices, the VIX is the most commonly used.

The VIX offers an instant measure of implied market volatility, though it doesn’t look backwards to recent volatility. Instead, it’s derived from the current option prices of the S&P 500 index and predicts market volatility over the next 30 days, reflecting investor concern levels.

How does the VIX Index work?

The VIX index rises when there is uncertainty in the market. The VIX does this by looking at the prices of options on the S&P 500 index. The VIX takes into account both call and put options (options to buy and options to sell, respectively). The relationship between options and the VIX is complex.

The VIX looks at both “call” and “put” options. A call option is a bet that the stock will go up, and a put option is a bet that the stock will go down. By studying the prices of these options, the VIX tries to understand how much investors think the S&P 500 will move.

The VIX is shown as a number. A low VIX number (like 12 or 15) means investors expect low volatility—small changes in stock prices. A high VIX number (like 30 or 40) means investors expect high volatility—big changes in stock prices.

So, the VIX gives us a snapshot of how uncertain or nervous investors are about the stock market’s future moves. It does this by looking at the prices of options on the S&P 500.

Why is the VIX index so important?

Here are the most important reasons why the VIX index is considered of interest:

1. It’s a real-time indicator of market volatility expectations for the next 30 days.
2. Investors use it to assess market risk, fear, or stress when making investment decisions.
3. You can’t buy shares of the VIX directly, but there are financial products that let you invest in a way that is influenced by the VIX.
4. The VIX index is popular because it allows investors to protect their investments when volatility is expected to be high (i.e., hedging).

VIX Volatility Index: how is it calculated?

Calculating VIX is a complex process. However, to get a better understanding of this indicator, here are the two main ways of calculating volatility in general:

• Historical calculation: This involves statistical calculations on past prices over a specific timeframe, including mean variance and standard deviation. The resulting standard deviation reflects risk or volatility. To predict future volatility, analysts often calculate it for recent months and expect it to follow a similar pattern. However, this is not how the VIX is calculated. The VIX is focused on “implied” volatility, meaning it looks ahead at what investors expect to happen, rather than what has already happened.
• Implied volatility: This method infers volatility from option prices. Options are financial instruments whose prices depend on the likelihood of a stock’s price reaching a specific level. This second method is closer to how the VIX works. The VIX uses the implied volatility from options prices to estimate how much investors think the S&P 500 will move. However, the VIX has a specific formula to do this, and it looks at both call options (bets the stock will go up) and put options (bets the stock will go down).

VIX value: investor anxiety level

VIX index values above 30 are generally linked to high market volatility and indicate an increase in uncertainty and concern among investors up to real fear or panic for levels above 45. Values below 20 generally correspond to less stressful moments in the markets and indicate increasing optimism.

This table indicates the level of investor anxiety according to the VIX value:

VIX on the stock exchange

The VIX index since the beginning of the year is as follows:

Despite numerous negative macroeconomic developments, including concerns about a recession and banking crises, investors have remained remarkably calm.

Between January and March, the index barely touched 25 points, indicating a mild sense of optimism. It was only in March that there was a slight uptick to around 27-28 points, suggesting some minor signs of stress. In light of these observations, it appears that despite the unfavourable news, investors have remained relatively calm and stress-free.

Here is the VIX in the last five years:

Once more, it becomes evident that genuine stress among investors was primarily experienced during the peak moments of the pandemic when it surged beyond 75 points.

Since then, it has steadily declined. However, there were occasional spikes during moments of elevated uncertainty in 2020 and in March 2022, triggered by the start of the conflict between Russia and Ukraine and the rise in raw material prices.

How to invest in the VIX?

Buy VIX ETPs

ETPs (exchange-traded products) are financial products that track the performance of a particular index, like the VIX. While you might not find these ETPs directly on the London Stock Exchange, you can access them through brokers that offer international trading. Check out this guide on the main ETPs: ETF vs ETC vs ETN.

Trade VIX CFDs

CFDs are financial contracts that let you speculate on the rise or fall of an asset like the VIX without owning it. These essentially track its performance and allow you to benefit from increases or decreases in its value. Here are some brokers to check out if you’d like to trade the VIX index:

• Interactive Brokers review
• Trading 212 review
• CMC Markets

Why trade VIX?

Using VIX instruments like Contracts for Difference (CFDs) to offset losses in a portfolio invested in the S&P 500 is a strategy known as “hedging.” The idea is that if the S&P 500 goes down, the VIX often goes up.

Here is how it works:

1. You’ll need to open an account with a broker that offers CFDs on the VIX, such as Interactive Brokers.
2. Once your account is set up, you can buy CFDs that follow the VIX. These are contracts that pay you if the VIX goes up and cost you if the VIX goes down.
3. Decide how much of your portfolio you want to protect. The amount of VIX CFDs you buy will depend on the size of the S&P 500 investment you’re trying to hedge.
4. Keep an eye on both your S&P 500 investment and your VIX CFDs. If the S&P 500 drops and the VIX rises, the gains from the VIX CFDs could offset the losses from the S&P 500.

Summary

Markets change, so you might need to adjust your hedge over time. This could mean buying or selling VIX CFDs to match any new investments in the S&P 500. When you feel that the market risk has passed or you no longer want to keep the hedge, you can sell your VIX CFDs to close the position.

Keep in mind:

• CFDs are complex instruments, so make sure you learn everything you should know about CFD trading.
• You can also use futures trading for hedging purposes.
• Options are also complex instruments, so learn about options trading before trading VIX to have a better understanding of how it works.

Frequently Asked Questions: VIX S&P 500