• Sharebar

" The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility." *www.cboe.com

In the media, the VIX is often referred to as the "fear" index. It spikes during times of crisis and market chaos. The index has a strong negative correlation to equity prices and reacts to events in other asset classes as well.

In the last decade, the VIX has evolved from an indicator to an active and liquid trading vehicle. Globally, more volatility trades through VIX-based derivatves prodicts than any other financial instrument. Because VIX futures and options trade openly in the secondary market the pricing od these products is transparent. This results in faster price discovery, greater liquidity, and markets that are more efficient than the OTC products that preceded them.

Those interested in understanding or intoducing volatulity into their portfolio as an asset class shoild understand the mechanics of VIX based producsts and how to best execute multi-product vega based strategies.

VIX Calculation Methodology:

The VIX index estimates the value of a one month variance swap on the SPX index and represents the market's expectation of volatility over the next month. The price of the VIX is derived from the value of a basket of SPX options. It measures the risk level priced into the equity volatility market and offers distinct advantages to using at-the-money SPX volatility.

Model Independent:
VIX derives its value directly from the prices of listed options on the SPX. Therefore VIX does not depend on any model assumptions.

Constant Maturity:
The VIX index always measures one month implied volatility. As a results, it is particularly useful for comparing implied volatility regimes.

Strike Independent:
The VIX index does not refer to any particular strike in the SPX but to the whole volatility surface. It allows a direct comparison between two different time periods even if the price level of the SPX is significantly different.
On any given day, VIX estimates the volatility of the next 30 calendar days.

For example, if first month SPX Car expires in 15 days and is 30 vol and second-month SPX Var expires in 45 days and is 33 vol, it follows that a weighted average of these values calculated around 30 days equals 31.5 vol. This is the value of the VIX.

Weekend effect:
The VIX always measures implied volatility over the next 30 calendar days. However, most market volatility is realized on business days and not weekend days. Consider that you are looking a the VIX index on a Friday (June 10). The next 30 days have 20 business days and 10 weekend days. However, on Monday, June 13 the next 30 days have 22 business dyas and 8 weekend days. On Friday the proportion of business days in the VIX is lowest. On Monday, the ratio of business days on the VIX index increases. Therefore, the total amount of volatility implied by the VIX -as measured over the 30 calendar days beginning on Monday - increases as well. Consequently, the VIX trends lower on Friday and higher on Mondays.

VIX Futures:

  • Expiration
  • You can think of VIX expiration much like SPX options expiration. Recall that for SPX expiration an investor must trade a basket of 500 stocks that represents the index on the opening print. This transaction replicates both the risk and the price level of the investor's expiring options or futures.

    Similarly, if an investor is long (or short) VIX futures, they can trade a basket of SPX options on the CBOE to offset the expiring VIX exposure.

    VIX futures and options settle 30 days prior to the next month's SPX expiration. At expiration, the index is composed of only one month's SPX options prices. It is precisely at the same time that the exact price level of the VIX can be replicated by trading this basket of options.

  • Term Structure
  • Since every VIX Future refers to a specific time period, the CBOE has listed contracts with multiple expiration dates. Currently, the CBOE lists the next seven months VIX futures. In a normal market environment, term structure is generally upward sloping. This implies there is less uncertainty in the near term versus the long term.

    While the VIX settles to the price of variance on expiration, the VIX futures represent the value of forward starting variance. In an upward sloping term structure, the VIX futures will generally trade at a higher price than a variance swap with the same expiration.

3

Comments (5)

  • trazer985's picture

    Useful post, just wanted to drop a note in against other hits this might get, that the CBOE VIX has nothing to do with the Swiss Exchange.

  • In reply to trazer985
    Working9-5's picture

    trazer985:
    Useful post, just wanted to drop a note in against other hits this might get, that the CBOE VIX has nothing to do with the Swiss Exchange.

    HAHA. Good one.

    Awesome post.

    CNBC sucks

    "This financial crisis is worse than a divorce. I've lost all my money, but the wife is still here." - Client after getting blown up

  • teenagepirate's picture

    when you say

    "Strike Independent:
    The VIX index does not refer to any particular strike in the SPX but to the whole volatility surface. It allows a direct comparison between two different time periods even if the price level of the SPX is significantly different.
    On any given day, VIX estimates the volatility of the next 30 calendar days.

    For example, if first month SPX Car expires in 15 days and is 30 vol and second-month SPX Var expires in 45 days and is 33 vol, it follows that a weighted average of these values calculated around 30 days equals 31.5 vol. This is the value of the VIX."

    That's not being independent of the strike price, that's being independent of the maturity date. I think it's impossible to be independent of strikes due to the vol smile, hence the use of variance swaps instead.

  • BTbanker's picture

    Market up, VIX down.

    There. Not that difficult to grasp.

  • In reply to BTbanker
    nonos's picture

    To unlock this content for free, please login / register below.

    Sign In with Facebook Sign In with Google

    Connecting helps us build a vibrant community. We'll never share your info without your permission. Sign up with email or if you are already a member, login here Bonus: Also get 6 free financial modeling lessons for free ($200+ value) when you register!