The Chicago Board Options Exchange (CBOE) Volatility Index – commonly referred to as the VIX – is the most widely used tool to gauge financial volatility. Used by traders of all asset types, the benchmark VIX index reflects both investor sentiment and market risk.
Also known as the fear gauge or fear index, financial volatility has a direct relationship with anxiety in markets. In other words, the more nervous investors are, the higher volatility will be.
How is Volatility Measured?
The VIX is a mathematical measure of how much the S&P 500 will fluctuate over the next 12 months, derived from the price data of S&P 500 index options. The more dramatic price swings are, the higher the level of volatility.
In general, the VIX rises when selling increases and falls when buying activity is more aggressive.
A Leading Indicator
The VIX is considered a leading indicator, meaning theoretically it can predict a market trend before markets begin to follow. However, like other indicators the VIX is not perfect and may not always foretell the future. The significance traders place on the VIX varies greatly based on their individual approaches to markets.
The value of the VIX is best understood as a percentage. For example, a VIX value of 33 can be interpreted as implied volatility of 33%.
History of the VIX
The VIX was first introduced in 1993 by the CBOE, after consultant Robert E. Whaley, also a professor at Vanderbilt University, developed the VIX for the Chicago Board of Trade (CBOT). The CBOE began working towards creating an options-based volatility index in the late 1980s, eventually tasking Whaley with the responsibility of turning their concept into a reality.
Originally based on eight S&P 100 put and call options, the exact methodology for calculating the VIX has changed over the years. As derivatives markets developed, in 2003 the CBOE joined forces with Goldman Sachs and updated the way VIX is calculated, adding a wider set of options based on the S&P 500 index.
Pictured above is a chart of the VIX index from 2007 to 2020. The VIX recently reached an all-time high on March 16, 2020, closing at a record of 82.69. The previous record was 80.74 from November 21, 2008.
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