You may have heard of the Volatility Index, also known by its acronym VIX, in the course of your trading activities. But what is this index, where should you use it and how should you interpret it in order to maximize the efficiency of your trading? This is what we suggest you find out here in more detail.
The VIX or Volatility Index is an indicator that was highlighted in 1993 by the Chicago Board Options Exchange or CBOE. It is, as its name suggests, an indicator for measuring the volatility of the US financial market. To calculate and estimate this volatility, the VIX is essentially based on the S&P500 stock market index.
More specifically, the CBOE is responsible for the daily calculation of this indicator. This indicator has become increasingly popular over time and is now followed by many investors in the United States. Even better, it is even possible to trade it as an asset.
Another common name for the VIX index is "The fear index" among Anglo-Saxons. This literally means "Fear index" in English. This eccentric name comes from the fact that the Volatility Index actually measures the nervousness of the markets. The VIX was originally created as an indicator, but is now considered more like an index in its own right.
This index is quoted in percentage points. The objective of the result obtained is to approximate the changes in the S&P 500 over a 30-day period in the future. This period is then annualized.
Following the success of the Volatility Index for the S&P 500, other indices for calculating volatility have been developed for other markets, such as the VNX for the volatility of the NASDAQ 100 or the VXD, which this time measures the volatility of the Dow Jones stock market index. But the VIX remains the benchmark volatility index for the US market.
If we look closely at the history of the analysis of market volatility, we see that the first index was created in 1986. Professors Menachem Brenner and Dan Galai were the first to create such a volatility indicator. At the time, these two professors published their research on the volatility index under the title "New Financial Instruments for Hedging Changes in Volatility" in 1989. At that time, the volatility index developed was supposed to be called the "Sigma Index". Brenner and Galai were then considering using this indicator as an underlying index for derivatives, mainly futures and options.
Later, in 1992, it was the CBOE, through the work of Professor Robert Whaley, who began research aimed at creating a volatility index that could be traded and indexed to the price of options. It took Professor Whaley only a year to come up with a volatility index called VIX in 1993. On that occasion, he will present a Volatility Index based on data from January 1986 to 1993.
As we have just seen, the VIX is not a simple volatility indicator but is also a real index on which it is possible to speculate directly. To trade the VIX, technical analysis will of course be used first and foremost since all graphical analysis tools are particularly well suited to it.
Traders who use the Volatility Index as an asset most often do so as part of good money management. The VIX is therefore used here as a risk indicator. For example and in case of normal market volatility, you take two at a time with CFDs for example, a high VIX can push you to reduce your positions and finally take only one lot. We know that when volatility is high, risk increases almost systematically. It is therefore preferable to be satisfied with a single lot in order to better control this risk. The VIX is often compared here to the standard deviation measure, which is also used to assess volatility.
It is also possible to speculate on the price of the VIX by using derivatives, most often options or futures. This possibility exists since March 24, 2004 for futures and, since 2006, this index is also accessible via options. Following the introduction of these possibilities to trade the VIX as an asset in itself, there has been a significant increase in the trading of options and futures contracts on this value with more than 100,000 contracts per day barely 5 years after their introduction. But before you start trading the VIX, you should check that this is the Volatility Index that we are presenting here because some brokers offer their own volatility indices.
Finally, some sophisticated investors also use an investment method based on market rhythms. Indeed, we know for example that during certain periods of the year such as between July 15 and August 15 or between Christmas and New Year, volatility is rarely present on the different markets. As a result, and if we observe that the VIX is high as these periods approach, some traders take a short position on it, which amounts to selling volatility. A fall in the price of this index due to a low transaction volume will thus be likely to be profitable for the latter.
To understand what the VIX tells us according to its level, it is necessary to delve into its history. By cross-checking the VIX calculated in the past with the trends that followed, it is indeed possible to set up a precise analysis model. Here is how to make an effective interpretation of this indicator:
First of all, when the Volatility Index level is between 10 and 15, it means that the market has a rather low volatility and that investors are rather confident. This therefore logically indicates an uptrend which therefore gives a buy signal.
When the VIX displays a level between 20 and 30, it rather indicates a market with high volatility and therefore a high degree of nervousness. However, the trend can remain bullish and taking strategic positions here proves to be a little more delicate and risky.
Finally, when the level displayed by the Volatility Index is higher than 30, this demonstrates very high market volatility. It is then frequent that we then see a significant drop in prices or even a major crisis.
However, before basing your investment strategies solely on this indicator, you should be aware that the VIX is not to be interpreted as such. Indeed, it is not the level of the Volatility Index that is most important here but its evolution over time. The variations recorded by the VIX will indeed give us more relevant information on investors' feelings about the market.
Thus, when the Volatility Index tends to move upwards, it shows nervousness and pessimism on the part of investors.
On the contrary, when the VIX index tends to fall, it shows some market optimism.
Before you start trading the VIX index or using it for your future stock market investment strategies, you should also look at its history. Since its creation, this index has indeed experienced extremely strong variations with several bullish peaks that have corresponded with major events and specific periods from an economic point of view.
On several occasions, a VIX level approaching or exceeding 40 has been observed, which is exceptional and most often indicates a period of major crisis from an economic point of view with abnormally high market volatility.
The first upward record for this index occurred in August 1998. The VIX was then 44.28 due to the monetary and financial crisis that hit Russia at that time. In September 2002, the VIX level also reached a high of 39.69 in the context of the Enron affair. However, the highest level ever reached by this index will be the one affected during the subprime crisis, i.e. on 24 October 2008 with 79.13. Other events will also lead to a significant rise in this index such as the Greek crisis with a VIX of 40.95 in May 2020, the Eurozone sovereign debt crisis in August 2011 with a level of 43.05 42.96 in September of the same year for the same reasons. Finally, the coronavirus pandemic also led to a VIX of over 40 in March 2020.
In view of these historical data, the effectiveness of the Volatility Index in periods of major economic crisis is therefore clearly evident.
To go even further, you are probably wondering how the Volatility Index level is calculated. In reality, this formula is far too complex for us to describe it in detail here. However, you should know that it uses different elements. Here are the details:
In particular, the formula uses the future on the S&P 500, which represents its maturity.
If you wish to learn more about the precise formula used to calculate the VIX index, you can consult the explanatory documents made available by the CBOE on the VIX. This documentation is available in English and is the only source about this indicator. However, in general, it is not necessary to understand this formula in order to know and interpret the results of this indicator, which will be provided to you in real time on any online trading platform.
As we have briefly mentioned above, the VIX is not the only market volatility index, although it was the first to be created. Indeed, other indices of this type were subsequently launched by the Chicago Board Option Exchange. These include the VXN, which is the volatility index dedicated to the NASDAQ 100 stock market index, and the VXD, which is the volatility index dedicated to the Dow Jones Industrial Average.
We will not dwell here on other volatility indices, but there are of course others. Indeed, most major stock market indices have their own volatility index, but the VIX remains the most closely followed in the world.