The Cboe Volatility Index (VIX) is a stock market index that serves as the primary indicator of stock volatility. More specifically, the index represents expectations of near-term price changes for the S&P 500 index (SPX). Investors often call this index the “fear gauge” because it measures negative market sentiment across the broader stock market.
After a rocky start to 2020 due to the global pandemic, the stock market reversed and ended the year quite strong. Wild swings and fluctuations in the market can cause investors to fear and panic. But savvy investors should know what to expect and how to react to volatility, especially given that Morgan Stanley recently predicted even more stock market volatility in 2021.
Keep reading to learn about volatility, how the VIX index tracks it and how to invest in the VIX.
What Is Volatility?
Volatility is a “statistical measure of the dispersion of returns for a given security or market index,” according to Investopedia. It’s measured as either the standard deviation or variance between returns.
But what does that mean, exactly? In practical experience, volatility refers to large swings of the overall market in either direction. Thus, volatility tends to increase as a stock or index price fluctuates strongly from an average price. Volatility decreases as prices become more stable and predictable. Investors should know that volatile assets are riskier than less volatile assets because prices are less predictable.
What Is the VIX?
The VIX is a real-time index created by the Chicago Board Options Exchange and currently maintained by Cboe Global Markets. VIX is the ticker symbol assigned to this popular volatility index.
The VIX is priced based on SPX index options with near-term expiration dates. It’s intended to provide an authoritative estimate of the constant, 30-day expected volatility of the U.S stock market. Investors can trade futures or options associated with the VIX.
As an essential index for investors to watch, the VIX provides a quantifiable measure of investors’ sentiment and current market risk. The reality of volatility can affect your 401(k), so investors need to know how to react.
How Does the VIX Measure Volatility?
The VIX measures volatility by tracking SPX options, both calls and puts, in the near future. The volatility index tends to have an inverse relationship with the S&P 500 index. Thus, when SPX prices fall, the VIX tends to rise. The opposite is also common, although it may not always happen that way.
According to the Cboe, the VIX calculates “up-to-the-minute” estimates of expected volatility. Real-time prices of “SPX options with more than 23 days and less than 37 days” are used to calculate the VIX index.
How To Interpret the VIX
The stock market is considered to be in a period of low volatility when the VIX is at 12 or lower. By contrast, high volatility is expected when the VIX is over 20. Clearly, if the VIX is over 30, markets are pretty rattled.
Good To Know
When markets first started to react to the start of the COVID-19 pandemic in early 2020, the VIX climbed higher than 80. The VIX hadn’t experienced that degree of volatility since the last financial crisis in late 2008.
Investors watching the VIX must anticipate large fluctuations in stock market prices as the VIX rises. Conversely, investors should expect relatively stable market prices when the VIX is low.
How To Invest In the VIX
ETFs With VIX Exposure
Several exchange-traded funds provide exposure to the VIX. An ETF is a particular type of fund that comprises various securities. ETFs are designed to match the results of the corresponding index. They tend to be cheaper, more accessible and have more liquidity than traditional mutual funds.
There are several options for investors to invest in funds that have VIX exposure. Here are a few examples:
- ProShares VIX Short-Term Futures ETF (VIXY): This ETF tracks the VIX short-term futures index. It represents the prices of near-term VIX futures contracts with an average maturity of one month. VIXY has a net expense ratio of 0.870%.
- ProShares VIX Mid-Term Futures ETF (VIXM): This ETF tracks the VIX mid-term futures index. It represents prices of VIX futures in the mid-term, with an average maturity of five months. VIXM also has a net expense ratio of 0.870%.
Investors can trade VIX options with monthly and weekly expirations during regular trading sessions. Options allow investors to manage portfolio risk based on their expectations of future volatility.
Investors can trade VIX futures with monthly and weekly expirations nearly 24 hours a day, five days a week. Futures allow investors to take advantage of potential market movements any time of the day.
VIX Investing Strategies
There are many strategies that investors use to take advantage of their expectations of future volatility. Here are a few common approaches to consider.
A stock market decline is one of the primary risks for most investment portfolios. Long exposure positions to volatility could hedge an equity portfolio against the downside risk of the general market. Institutions and individual investors alike can purchase VIX futures or options contracts to offset this risk.
Investors can use VIX options and futures contracts as a simple “pure-play” trading strategy based on their expectations of future volatility. Investors who expect volatility to increase in the future can purchase call options to take advantage of that movement. They can also buy put options if they anticipate decreasing volatility and increased stability.
Here are the key aspects to understand about the VIX:
- The VIX measures stock market volatility and trends inversely to the SPX.
- Low VIX prices indicate relative stability; high prices indicate high volatility.
- Investors have several options for investing in the VIX, including ETFs, options contracts and futures contracts.