Understanding the Wallstreet’s Volatility Index or VIX
The Chicago Board Options Exchange (CBOE), also called the Volatility Index (VIX), is a key measure to gauge the market volatility on Wallstreet. Volatility is mostly used to understand the market sentiment and the risk appetite; hence, the CBOE Volatility Index is also known as Wallstreet’s “Fear Index” or the “Fear Gauge”. A volatility index level of 20 and above is normally considered high, while a level of 12 or below mostly exhibits low volatility in the markets. VIX Index is currently trading at around 28 levels which indicates that the volatility on the markets remains high; however it is lower than what we saw during the Russia-Ukraine crisis in the beginning of this year and the levels seen during the onset of the pandemic in March 2020.
The CBOE or VIX is a real-time index representing the market’s expectations to assess the relative strength of any price changes on the S&P 500 index (SPX). Market participants closely monitor the VIX levels to see if the markets are overheated or cooling off in the near term. This helps investors to make their buy/sell decisions in the near term.
Exhibit 1: Historical trends on the VIX Index over the last two decades
VIX Index peaked higher ahead of the Fed’s interest rate hikes this year
The VIX Index is a financial benchmark designed to be an up-to-the-minute market estimate of expected volatility in the S&P 500 Index. It is calculated by using the midpoint of real-time S&P 500 Index (SPX) option bid/ask quotes. The VIX Index generally tends to have an inverse relationship with the S&P 500 Index and historically, when the S&P 500 Index declines the VIX Index generally tends to increase. Simply put, the VIX Index tells us the level of the expected volatility of the S&P 500 Index for the next 30 days, with a 68% confidence level, or one standard deviation of the normal probability curve. As the fed raises interest rates this year and there is a lot of uncertainty in the market, the VIX index was seen trading higher around the FOMC meets.
How does the VIX index work?
Although the VIX Index isn’t expressed as a percentage, it can be understood as one. For example, if the VIX Index is at 28, this represents an expected annualised change with a 68% probability of less than 28% in the S&P 500 Index, in either direction. With the S&P 500 Index trading at 3,800 levels (as of June 30th), this correlates into a projected range of 2,808 – 4,992 for the index over the next year. Calculating potential movement in the S&P 500 Index using the VIX Index on a shorter basis is a bit more complicated. In summary, the comparison between the VIX Index and movement in the S&P 500 Index is close, with about 80% correlation, which confirms the reality of the two generally tending to move in opposite directions most of the time. In addition, the correlation generally tends to remain relatively stable throughout different market conditions.
Exhibit 2: VIX Index trend in 2022
Source: Tradingview.com, June 2022
VIX Index averages around 26 levels in 2022
Although the volatility index has more than doubled over the past year, it is still lower than the levels seen at the start of the pandemic in 2020. So far in 2022, the VIX index has recorded an average close of around 26.3 which is on track for its fifth-highest annual average since the index began in 1990.
Exhibit 3: Average annual VIX trends over the years
Key Factors likely to impact the volatility in the near term
- The ongoing geopolitical tensions in Russia/Ukraine
- The Fed’s tighter monetary policy and interest rate hikes
- Higher inflation numbers
- Pandemic-induced restrictions in China