How the VIX Index Works

How the VIX Index Works

VIX or Volatility Index, also known as “Fear Gauge” or “Fear Index”, globally recognized and followed by a variety of market participants as a daily market indicator, created by the Chicago Board Options Exchange (CBOE), is a market index used in real-time which produces a measure of constant, 30-day expected volatility of the U.S.,

t, derived from real-time, mid-quote prices of S&P 500 Index call and put options.  It is a way for analysts and portfolio managers to measure market risk, fear, and stress before making any investment decisions.

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In a market that is rising, stock prices are less likely to be fragile and options premiums are fairly low, hence this leads to a lower VIX in the market and the situation goes vice versa. Volatility Index, while being in a familiar stability range, increases when put option buying goes up and the reverse happens when call buying activity rises. The daily movement of VIX tends to be 4 times more than the movement of the S&P 500 index.
The movement of VIX on the SPX market is mostly looked over by institutional investors. A single SPX Option either calls or put has the leverage of around $200k in stock value.

Unlike other indices in the market, the Volatility Index works on the computation of option prices, mostly on the option prices of the S&P 500 index, instead of stock prices.
There are various ways to figure out the volatility of option prices as one of the key components in the pricing of SPX options is how volatile the S&P 500 will be between the present time and on the date of expiration or maturity.

Keeping aside the standard way of pricing for options, the Black Scholes model that works on the key assumption that volatility will equal for all options available, the CBOE’s creation of the Volatility Index comes in a lot handier.
The CBOE created the Volatility Index (VIX) with a key objective of making money on the volatility of the options. This index works as a base to a variety of products on volatility.
CBOE offers a handful of VIX Options, which follow the expiration date of CBOE’s VIX Futures and not directly the VIX Index.

A few versions of the VIX have been created, one of them being the VXO which was introduced in the year 1992, implementation of which turned out to be expensive for the CBOE as the market-makers needed a cost-effective approach to the hedge which could not be possible as hedging of the 1992 version of VIX required frequent balancing of OEX (S&P 100 Index) options.
Another version that came out with a new method to allow the market makers to hedge their positions under minimal cost was in the year 2003. Under this version of VIX, the positions could be held with a static portfolio of SPX options until the expiration date of VIX Futures.

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Thus, the key objective of getting the Volatility Index in the market and working it the right way to make money on volatility is getting accomplished for the CBOE as they have been generating millions in their revenue from the highly profitable transaction fees for trading in VIX Futures.

The Volatility Index is not the ideal approach to predict future movement in the market but instead works as a strong and reliable base for investors to find a growing opportunity in volatility-based products available in the market.

Author: Palak Arora


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