Definition
The Volatility Index, also known as the VIX, is a measure created by the Chicago Board Options Exchange (CBOE) that reflects the stock market’s expectations of volatility over the coming 30 days. It is often referred to as the “fear gauge” or “fear index” because it shows the market’s anticipation of near-term volatility. The VIX is considered a leading gauge of market risk, with higher values indicating greater expected volatility.
Key Takeaways
- The Volatility Index, often referred to as the ‘fear index’, is a measure that captures the market’s expectations of future volatility. It gives traders an idea of how much the market expects the stock or index to swing in the near term.
- It is based on options prices of an index or a stock. As market participants buy and sell these derivatives, it reflects how much they expect the market to move, making the Volatility Index a crucial risk assessment tool.
- The higher the Volatility Index, the higher the fear in the market, and vice-versa. Thus, this index is inversely proportional to market stability and can indicate upcoming economic uncertainty.
Importance
The Volatility Index, also known as the “fear gauge”, is an important financial term because it offers a measure of market risk and investor sentiment. Typically calculated by the Chicago Board Options Exchange (CBOE), it predicts the stock market’s expected volatility conveyed by S&P 500 stock index option prices.
Investors and financial experts monitor this index as fluctuations can indicate the market’s prediction of future volatility. When the index rises, it implies increased market uncertainty and risk, signaling potential market declines.
Conversely, a falling index indicates market stability and investor confidence. Therefore, the Volatility Index serves as an essential tool in evaluating market trends, managing risk, and making informed investment decisions.
Explanation
The Volatility Index, often referred to as the ‘fear gauge’, serves as a critical tool used by traders and investors across the globe to gauge the stock market’s perceptions of risk, fear, and stress. It plays a cardinal role in assessing market expectations of near-term volatility conveyed by stock index option prices.
Essentially, it provides insights into investor sentiment and market volatility, helping individuals and entities in making informed financial decisions. Primarily, the Volatility Index is used for hedging against market downturns, as it typically tends to rise when stocks fall, making it a valuable diversification tool.
By this measure, it provides traders and investors with the means to protect their portfolios against sudden market declines. This is also used by speculators for betting on dramatic market movements.
Hence, the use of the Volatility Index spans from risk management, investment strategy formulation, to executing speculative bets.
Examples of Volatility Index
CBOE Volatility Index (VIX): This is also known as the ‘Fear Gauge’ and is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. It is derived from the price inputs of the S&P 500 index options, aiming to reflect investors’ consensus view of future (30-day) expected stock market volatility.
NASDAQ Volatility Index (VOLQ): This index measures the expected 30-day volatility of the NASDAQ-100 Index, a tech-heavy stock index. VOLQ is the “Fear Gauge” for the tech sector and gives investors a snapshot of the expected future volatility in tech stocks.
EU VIX: This is the volatility index for the European Union. Similar to other volatility indices, the EU VIX is derived from the implied volatility of options on the EURO STOXX 50 – a stock index of Eurozone stocks. It is used to gauge the expected volatility of European stocks.These Volatility indices serve as market indicators for investors and traders, guiding decision-making based on expected market volatility.
FAQs on Volatility Index
What is a Volatility Index?
A Volatility Index, often known as VIX, is a measure of expected price fluctuations in the S&P 500 Index options over the next 30 days. The Volatility Index is widely considered the foremost indicator of stock market volatility and investor sentiment.
How is the Volatility Index calculated?
The VIX calculation formula combines the weighted prices of many S&P 500 Index options with different strike prices, across all expiration dates. A higher VIX value indicates that traders anticipate the S&P 500 Index to change drastically in the near future.
How can you use the Volatility Index?
Investors and traders use the VIX to monitor market risk, fear, and stress before they take investment decisions. Derivatives of the VIX, such as VIX options and futures, also provide hedging opportunities against market volatility.
What is the significance of high and low volatility?
High VIX values mean that investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX values come during periods of financial stress. Low VIX values imply that market risk perceptions are relatively low.
Related Entrepreneurship Terms
- VIX: It’s the ticker symbol for the Chicago Board Options Exchange’s Volatility Index. It’s a real-time market index representing the market’s expectations for volatility over the coming 30 days.
- Implied Volatility: The estimated volatility of a security’s price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish.
- Historical Volatility: This is an annualized statistical measure of the dispersion of returns for a given security or market index over a specific period.
- Volatility Skew: This follows from the observation that options that are out-of-the-money often have higher implied volatilities than at-the-money options.
- Volatility Arbitrage: This is a trading strategy that profits from the difference between the forecasted future price-volatility of an asset, like a stock, and the implied volatility of options based on that asset.
Sources for More Information
- Investopedia: This site provides definitions of a wide range of financial terminology and concepts, including a comprehensive article on the Volatility Index.
- Bloomberg: Bloomberg is a global business and financial news source that often includes analyses of financial markets and indices, including the Volatility Index.
- CNBC: This global news source provides a finance-specific section where the Volatility Index is often discussed.
- Cboe Global Markets: This is the official website for the exchange that created the Volatility Index (also known as the VIX), so it contains factual and authoritative information about the index.
