Wall Street's Fear Gauge

There’s a lot to consider when investing in the stock market. Because of this, the Volatility Index (VIX) is a crucial tool for investors. Often referred to as Wall Street's "fear gauge," the VIX provides insights into market volatility and investor sentiment.

Let’s examine the VIX, how it's calculated, and some considerations when using it as a tool to gauge investments.

What is the VIX?

The VIX, or Volatility Index, was introduced by the Chicago Board Options Exchange (CBOE) in 1993.¹ It measures the market's expectation of 30-day forward-looking volatility based on the prices of the Standard and Poor’s 500 (S&P 500) index options. In other words, the VIX quantifies the level of fear or complacency among investors, offering a real-time snapshot of market sentiment.

How is the VIX Calculated?

The calculation of the VIX is complicated and involves several factors, including options, weighting, formulas, and adjustments.²

• Options Selection: The VIX uses a wide range of S&P 500 index options, focusing on those with a maturity of around 30 days.
• Weighting: The selected options are weighted based on their prices, with near-the-money options (those whose strike price is close to but not at the current underlying price) significantly impacting the index.
• Formula Application: The weighted options prices are then fed into a formula that estimates the expected volatility. This involves summing the weighted prices and applying a series of mathematical adjustments to account for the time value of money and other factors.

The result is a single number representing the expected annualized change in the S&P 500 index over the next 30 days, expressed as a percentage. For example, a VIX level of 20 suggests an expected annualized volatility of 20%. As of Friday, November 8, 2024 the VIX finished at 14.94 down 32% on the week, one of the biggest weekly decreases in the last three years as investors celebrated Trump's quick decisive victory and political clarity.³

Interpreting the VIX

Understanding the VIX requires interpreting its output in terms of market conditions:⁴

• Low VIX (Below 20): A low VIX indicates a stable market with low expected volatility. Investors are generally optimistic, and the market is calm.
• Moderate VIX (20-30): This range suggests moderate uncertainty. While not overly fearful, investors are cautious and aware of potential risks.
• High VIX (Above 30): A high VIX signals significant fear and uncertainty in the market. It often coincides with market turmoil, sharp declines, or economic crises.

Practical Uses of the VIX

Investors and financial professionals use the VIX for various purposes, including risk management, hedging strategies, and market timing.

• The VIX helps investors assess the level of market risk and adjust their portfolios accordingly. A rising VIX might prompt a shift toward safer assets, such as bonds or gold.
• Options and futures based on the VIX allow investors to hedge against potential market downturns. By holding positions that gain value when the VIX rises, investors can offset losses in their stock portfolios.
• Some investors use the VIX to time their market entries and exits. A high VIX may signal a buying opportunity, as extreme fear can lead to oversold conditions and eventual market recovery.

Limitations of the VIX

While the VIX is a valuable tool, it has limitations.⁵ It only provides a 30-day outlook, which may not capture longer-term trends or risks. It is also reactive, reflecting current market sentiments rather than predicting future events. Lastly, understanding and interpreting the VIX requires a good grasp of options pricing and market dynamics, which can be challenging for new investors.

The VIX is one indicator for understanding market volatility and investor sentiment. By measuring expected future volatility, the VIX offers insights into the collective emotions of market participants. While it has limitations, the VIX remains a valuable tool for risk management and hedging.