by Jason Jenkins, Investment U Research
Tuesday, March 6, 2012
The Chicago Board Options Exchange’s (CBOE) VIX is a term that’s been thrown around a lot lately. Many investors use it as a market-timing indicator, but most of us don’t know what it is or how it works. Let’s take a look…
VIX is the symbol for the Chicago Board Options Exchange’s volatility index. It’s a weighted mix of the prices for a blend of S&P 500 Index options, from which implied volatility is derived. In laymen’s terms, it measures how much people are willing pay to buy or sell the S&P 500, with a higher volume of options suggesting more uncertainty in the marketplace.
The VIX Measures Implied Volatility
Implied volatility is the expected volatility of the underlying security – so we’re looking at a wide range of options on the S&P 500 Index. The VIX concentrates on the price volatility of the option markets, not the volatility of the index itself.
If implied volatility is high, the premium on options will be high, and the opposite is true. When investors see options premiums increase, there’s the assumption that we can expect future volatility of the underlying stock index, which represents higher implied volatility levels.
This VIX is an attempt to quantify fear in the marketplace because it reflects investors’ best predictions of near-term market volatility, or risk.
Rule of Thumb (usually): The VIX goes up when there’s turmoil in the market, and goes down when investors are quite content or at ease with the economic outlook.
What to Do With All This Technical Analysis…
This can get pretty convoluted, so let’s recap:
- The VIX measures the implied volatility (IV) in the prices of a basket of put and call options on the S&P 500 Index.
- The VIX is used as a tool to measure investor risk.
- A high reading on the VIX marks periods of higher stock market volatility.
Now how can the VIX be useful? Volatility works well to help identify market bottoms based on high volatility.
In most cases, when the VIX goes up, the S&P 500 goes down. When the VIX is at a high, the S&P 500 is at a low, which may be an excellent buying opportunity. However, you must ask yourself: If the VIX is very high, is there still a possibility that the market could take a further tumble?
This underlying fear makes buying during high stock market volatility an act not for the faint of heart. But, investors who used the high on the VIX to time their buys entered the market at or near the low. For us long-term investors, it’s a pretty good indicator of when the stock market is at or near a high – these are times when we see low or little volatility.
Remember, the VIX doesn’t give you the exact market high or low, but it’s going to put you in the neighborhood of both.