CBOE Volatility Index - VIX

The Volatility Index helps Determine Market Direction and Profitability!

by Ian Harvey

VIX sign


The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility.

This measure of implied volatility in trading of S&P 500 futures takes place on the Chicago Board Options Exchange. The volatility index is calculated using a formula that considers a large number of option strike prices, supposedly in a way based on current financial research and practice. Values for VIX tend to be between 5 and 100.

There are three variations of volatility indexes: the VIX volatility index tracks the S&P 500, the VXN tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average.

The Development of the VIX

1986 - The VIX Index was introduced to the AMEX by Prof. Dan Galai (picture right) and Prof. Menachem Brener (picture left).

1987 - The VIX Index was introduced to the CBOE by Prof. Dan Galai and Prof. Menachem Brener.

1993 -

1. The VIX Index is introduced in a paper by Professor Robert E. Whaley of Duke University.

Robert E. Whaley

Robert E. Whaley, Valere Blair Potter Professor of Management in Finance and Co-Director of Financial Markets Research Center, is a renowned expert in the field of derivative securities, including contract valuation and risk management, market microstructure and market volatility. His distinguished teaching career, numerous articles, and many books have brought him national and international recognition in both the business and academic worlds. Among his many industry innovations are the development of the Market Volatility Index (VIX), the NASDAQ Market Volatility Index (VXN) and the BuyWrite Monthly Index (BXM) for the Chicago Board Options Exchange. Professor Whaley has served on the board of directors of the American Finance Association and the Western Finance Association as well as on the international advisory board of the University Centre for Financial Engineering at the National University of Singapore.

2. In 1993, the Chicago Board Options Exchange (CBOE) introduced the CBOE Volatility Index, VIX, which was originally designed to measure the market’s expectation of 30-day volatility implied by at-the-money S&P 100 Index (OEX) option prices. The VIX soon became the premier benchmark for U.S. stock market volatility. It is regularly featured in the Wall Street Journal, Barron’s and other leading financial publications, as well as business news shows on CNBC, Bloomberg TV and CNN/Money, where the VIX volatility index is often referred to as the “fear index.”

2003 – The CBOE together, with Goldman Sachs, updated the VIX to reflect a new way to measure expected volatility, one that continues to be widely used by financial theorists, risk managers and volatility traders alike. The new VIX volatility index is based on the S&P 500 Index (SPXSM), the core index for U.S. equities, and estimates expected volatility by averaging the weighted prices of SPX puts and calls over a wide range of strike prices. By supplying a script for replicating volatility exposure with a portfolio of SPX options, this new methodology transformed VIX from an abstract concept into a practical standard for trading and hedging volatility.

2004 - On March 26, 2004, the first-ever trading in futures on the VIX Index began on the CBOE Futures Exchange (CFE) with its new, all-electronic CBOE Futures ExchangeSM.

2006 – In February 24, the CBOE launched VIX options, the most successful new product in Exchange history. In less than five years, the combined trading activity in VIX options and futures has grown to more than 100,000 contracts per day.

2007 – March 26, the CBOE Futures Exchange (CFE) rescaled the CBOE Volatility Index (VIX) and the CBOE DIJA Volatility Index (VXD) futures contracts in order to bring the traded futures contract prices in line with the underlying index values published by the Chicago Board Options Exchange (CBOE). The rescaling did not change the dollar value of the VIX and VXD futures contracts, and it will not change the dollar value of each tick.

By 2009 - In less than five years, the combined trading activity in VIX options and futures has grown to more than 100,000 contracts per day.

Interpreting the VIX

VIX is the ticker symbol for the Chicago Board of Exchange Volatility Index. VIX is an index which provides a general indication on the expected level of volatility (implied volatility) in the US market over the next 30 days. This allows anyone to tell if the US stock market is volatile or not just by looking at the VIX.

caution sign

Before the invention of the VIX, investors could only tell if the market is volatile or not through experience and gut feel. VIX literally quantified the concept of volatility, allowing traders to use it as an indicator or to simply trade or hedge against volatility directly.

The CBOE has a rather complex formula for averaging various options for the S&P 500 futures to get a hypothetical, normalized, 'ideal' option. The volatility component can be isolated from the price of this ideal option. That's VIX. Although both 'put' and 'call' options are included in the calculation, it is the 'put' options that lead to most of the excess demand that VIX measures.

The Importance of the VIX

The VIX volatility index is especially important in options trading because volatility can make or break certain options strategies. Understanding what VIX is and how you can use it to your advantage would certainly result in better and more consistent options trading results.

Daily VIX from 2009

This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".

The trend of the VIX also provides an indication to the trend of the stock market. In a bull market, the VIX is typically trending downwards and in a bear market, the VIX is typically trending upwards. The VIX was trending downwards steadily in the big bull run of 2003 to 2006. Observing a chart of the VIX since January 2009, allows us to see the drop in volatility after the 2008 market crash.

Futures on the VIX, CBOE's trademark Market Volatility Index, also provides a pure play on implied volatility independent of the direction and level of stock prices. VIX futures may also provide an effective way to hedge equity returns, to diversify portfolios, and to spread implied against realized volatility.

The Investor “Fear Gauge”

VIX is based on real-time option prices, which reflect investors' consensus view of future expected stock market volatility. During periods of financial stress, which are often accompanied by steep market declines, option prices - and VIX - tend to rise. Therefore, it is obvious that the greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline.


It is important to note, however, that past performance does not necessarily indicate future results. When the market is trending steadily upwards, there is generally a low level of volatility in the market as complacency sets in and more call options are bought than put options. Conversely, when a market is falling, there is generally widespread panic in the market causing a high level of volatility as more put options are bought than call options. This correlation is also why the Put/Call Ratio is read in conjunction with the VIX volatility index to provide more insight into the state of volatility in the market. Together, the Put Call Ratio and the VIX have been known as "investor fear gauges".

Picture above - Rembrandt, "Storm on the Sea of Galilee" (1633)

VIX Measures Market Sentiment

The VIX is said to measure market sentiment (or, more interestingly, to indicate the level of anxiety or complacency of the market). It does this by measuring how much people are willing to pay to buy options, typically 'put' options which are a bet that the market will decline. When everything is right in the world, nobody wants to buy put insurance, so the VIX has a low value. But when it looks like everything is falling apart, everybody becomes cautious and wants insurance, and the VIX provides for this instance. Practically, even in the best of times, the VIX may not get below 12 or 13. And even in the worst of panics, such as in 1998, the VIX did not break much above 60.

For Example:- When the US stock market entered a sharp correction in January 2008, the VIX also spiked to a multi-year high of over 37. Conversely, when the US stock market was at the height of its bull run in 2006, VIX was as low as 8.6, which again was a multi-year low.

VIX as a Contrarian Indicator

Many view the VIX as a contrarian indicator. High VIX values such as 40 (reached when the stock market is way down) can represent irrational fear and can indicate that the market may be getting ready to turn back up. Low VIX values such as 14 (reached when the market is way up) can represent complacency or 'irrational exuberance' and can indicate the market is at risk of topping out and due for a fair amount of profit taking.

VIX and SPX 500

There's no guarantee on any of this and VIX by itself is not necessarilya indicator of market action, but is certainly an interesting indicator to help you get a sense of where the market is.

As a contrarian indicator, the higher the VIX, the more bearish the market is and conversely, the lower the VIX, the more bullish the market is.

'Implied Volatility'

According to Investopedia “implied volatility,” in general, means increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets.

In addition to known factors such as market price, interest rate, expiration date, and strike price, implied volatility (IV) is used in calculating an option's premium. IV can be derived from a model such as the Black-Scholes Model.

Implied volatility is sometimes referred to as "vols". 'Volatility' is one of the most important factors that go into the pricing of options. Simply put, this means the extent to which the price of something has changed over a year, measured as a percentage. An option on a more volatile stock or future will be more expensive. But options are just like any other asset, and are priced based on the law of supply and demand. If there is an excess of supply compared to demand, the price will drop. Conversely, if there is an excess of demand, the price rises. Since all the other parameters of the option price are predictable or measurable, the piece that relates to demand can be isolated. It's called the 'implied volatility'. Any excess or deficit of demand would suggest that people have a difference in expectation of the future price of the underlying asset. In other words, the future or 'expected volatility' will tend to be different from the 'historic volatility'.

Volatility Formula

Historical volatility depicts the degree of price change in an underlying security observed over a specified period of time using standard statistical measures. It is not a forecast of future volatility. Implied volatility is the market's prediction of expected volatility, which is indirectly calculated from current options prices using an option-pricing model. The exact formula for historical volatility is shown on right.

The Importance of Understanding 'Implied Volatility'

It is important to be able to quantify and measure volatility in options trading and this is what makes the VIX so essential. Diagram below shows the

'Volatility Smile'. **

Volatile markets are characterized by wild swings with big up days followed by sudden sharp drops. Volatile market conditions make it extremely hard for traders and investors to decide if it is time to take profits or cut losses as stocks could suddenly become bullish or bearish.

Volatility affects options trading as well. Higher volatility means higher options premiums, making it extremely disadvantageous to execute debit options strategies. Higher options premium also mean a much higher breakeven point for every debit options strategies, making it harder for them to make money. On the other hand, higher volatility also makes credit options strategies or covered calls extremely profitable as there is now much more extrinsic value to profit from. Without a means to measure the level of volatility in the market, options traders would not be able to make a completely educated decision on the options strategy to use for the prevailing circumstances.

Chart of the VIX from January, 2006 until May, 2010

Chart of the VIX from January, 2006 until May, 2010

How the VIX Is Calculated

The calculation for the VIX volatility index has undergone some major changes since September 2003. The original VIX (now known as VXO) was calculated by averaging the implied volatility of at the money (ATM) options of the S&P 100 (OEX) using the Black-Scholes Model. There were obviously too many flaws in the original VIX calculation as the OEX, comprising only 100 stocks, cannot be taken as the closest representation of the stock market and implied volatility derived through the Black-Scholes Model are littered with flaws inherent in the Black-Scholes Model itself.

The new VIX calculation, which results in the present VIX, estimates implied volatility by a weighted average of a wide range of strike prices in the S&P 500 using a newly developed formula which is independent of any currently known models. In fact, just by switching to using the S&P 500 instead of the S&P 100, the VIX volatility index is much more correlated to actual market volatility, increasing the value of VIX futures and VIX options as hedging tools. Using a range of strike prices, rather than just at the money options, also acknowledges the difference in implied volatility across different strike prices (the volatility smile which is shown by the diagram in the previous section **).

To arrive at the VIX value, a wide range of In The Money to Out Of The Money call options and put options of two expiration months bracketing the nearest 30-day period are selected. The implied volatility of all options of each of the selected months are estimated on a price weighted average basis in order to arrive at a single average implied volatility value for each month. Finally, results of the two months are interpolated using a 30 days constant and then a percentage derived from the square root of that result.

How to Calculate the VIX

VIX is a measure of expected volatility calculated as 100 times the square root of the expected 30-day variance (var) of the S&P 500 rate of return. The variance is annualized and VIX expresses volatility in percentage points.

Vix Formula


It is important to remember that the CBOE Volatility Index (VIX) is a statistic, not a stock and, as such, it behaves quite differently compared to a stock.

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