What Is the CBOE Volatility Index (VIX)?
The Volatility Index, or VIX, is a real-time measure of the market’s expected volatility in the S&P 500 index for the next 30 days. The Chicago Board Options Exchange created the VIX in 1993, initially based on the S&P 100 options. In 2003, the calculation method was updated with input from Goldman Sachs to include a broader range of S&P 500 options, making it became a better measure of investor sentiment.
The volatility index is also known as the “fear index” because it is a measure of investor fear. When investors expect sudden big price movements due to economic news like geopolitical tensions or financial crises, S&P 500 option demand will increase, driving up option prices and the VIX rise. In periods of tranquil markets, option demand decreases, which leads to the VIX decreasing.
Whereas historical volatility seeks to measure past moves that have already occurred, the VIX is forward-looking and reflects the expected market anticipation of what will be. The S&P 500 represents virtually 80 percent of the total US stock market cap; hence, the VIX is largely used by institutional investors, hedge funds, and analysts as a hedging tool.
A higher VIX generally foretells rising uncertainty in the market, whereas a falling VIX indicates stability. Therefore, not only do traders measure market risk using the VIX, but they also use it for hedging portfolios or wagering on volatility by trading derivatives such as VIX futures and ETFs. Because of the strong negative correlation between stock market performance and VIX, VIX is an important tool to describe overall market sentiment and associated risks
How Does Volatility Index (VIX) Work?
The VIX Index measures the market’s expected near-term S&P 500 volatility by pricing SPX options. Instead of tracking the current price of the S&P 500, the VIX measures investor sentiment; higher option prices suggest more significant uncertainty, and lower prices indicate stability.
Because there is an inverse correlation between volatility and stock market performance, the VIX tends to trend higher when the markets go down due to fear and uncertainty, . Conversely, a drop in the VIX signals confidence and stability, which commonly accompany market uptrends. VIX Levels Explained:
Below 15 (Low Volatility, Market Optimism): Readings below 15 suggest high investor confidence and low-level fears of unusual economic disturbances or significant downturns. The market seems stable, and stocks usually perform well in such an environment.
15 to 25 (Normal Market Fluctuations): This VIX reading is typical for behavior in markets where some volatility is present but within an acceptable range. Investors remain aware of risks, but fears or euphoria are not strong enough to move a market.
25 to 30 (Growing Investor Concern): When the VIX enters this range, it signals a turning market. Increased concerns about economic factors, policy shifts, or geopolitical tensions have investors looking for protection. Increased hedging and a short-term correction are often in play.
Above 30 (High Volatility, Market Fear): The VIX set above 30 indicates great uncertainty usually associated with a financial crisis, unanticipated global disruptions, or a severe recession. Investors shift toward being risk-averse, selling pressure rises, and rising demand for safer assets.
How the VIX Index is used
The VIX is a valuable indicator that can be incorporated into a general trading plan, giving a heads-up for reversals in the S&P 500 and the general stock market. A spike in the VIX generally indicates that the market is too bearish, perhaps a time to buy. In contrast, Low readings could be an indication of bullishness. However, these readings must always be supported by a broader view of technical and fundamental analysis to determine precise entry and exit points. Notice that the VIX may remain above or below some level for an extended period.
VIX Strategies
A popular saying in the investment world is: “When VIX is high, buy; when VIX is low, watch out!” When the COVID-19 pandemic first appeared in 2020, the VIX rose and peaked at 65 in March 2020; at the same time, the SP500 bottomed and began an uptrend until 2020. This move is an example of the inverse relationship between the VIX and the S&P 500. Investors can take advantage of the VIX peaking or bottoming to trade.
The long-term VIX chart shows key support and resistance areas. For example, early history indicates that VIX had a key support level around 19, which it revisited in subsequent years, even during extended trends like the 2003–2005. At that time, a hit to resistance meant volatility, and investors would buy stocks, especially those tracked by the S&P 500. Conversely, a bounce at support levels signaled a market top and warned of a potential decline in the S&P 500.
A useful lesson from this analysis is the volatility of implied volatility (IV). During normal times, the volatility index fluctuates between about 18 and 35, with occasional outliers and ranges of 10 and 85, respectively. Eventually, the VIX always moves toward its mean, and even after the extraordinary bear market of 2008–2009, it eventually returned to normal levels.
Optimizing Options
The maxim “If the VIX is high, it’s time to buy” relies on the premise that excessive bearishness sends VIX to extremes. Under these conditions, the market will likely become bullish as volatility index reverts back to its mean. The best options strategy in this case is to take a delta-positive, vega-negative position meaning sell put options. A delta-positive position guarantees that when stock prices move up, the value of the option goes up, and a negative vega position benefits from a drop in implied volatility.
On the other hand, “When the VIX is low, look out below!” indicates that the market is poised to drop and that volatility index is going to rise. Anticipating volatility index going up, a bearish options trade is to be in a delta-negative, vega-positive position such as the buying of put options. The trade is designed to make money with a falling market and a rise in implied volatility.
