Volatility Index (VIX): What Is It And How Is It Measured?
While many market instruments and sectors may stumble when faced with uncertainty and fears, the VIX Volatility Index thrives. The CBOE Volatility Index, otherwise abbreviated as the VIX, is a benchmark index that has experienced price swings amidst the volatility in 2022. While the VIX fell at times, it also soared last year as recession fears and inflation pressures coupled with geopolitical tensions and uncertainties continue to reign over the market. So here’s what you need to know about the VIX Index.
What Is the VIX and What Does the VIX Measure?
The Chicago Board Options Exchange Volatility Index or the VIX is a real-time index used to estimate S&P 500 relative strength based on market expectations. In other words, this index measures the implied US market’s volatility in the upcoming 30 days based on investors' and traders' sentiments.
Accordingly, it reflects how the majority of market participants think the S&P 500, which includes the biggest publicly traded companies in the US will fare over the course of the upcoming 30 days.
Moreover, the VIX index, which uses the S&P 500 index as a benchmark for overall market sentiment, is often called the "Fear Index" since it highlights investor apprehension.
What Is a Good VIX?
As a rule of thumb, traders should know that there is a correlative relationship between fear levels and VIX levels. As such, higher market fear and volatility mean higher VIX levels. Along the same line, anything over 30 indicates great uncertainty.
As for what a good VIX measurement is, VIX values below 20 indicate a more stable and less volatile market atmosphere. For example, in 2022 as the war in Ukraine, recession fears, high inflation, interest rate hikes, and the COVID-19 pandemic took a toll on market sentiment, the VIX soared by 70% up till the middle of October whereby it reached levels above 30 to later level out in the final 2 months of the year.
Overall, throughout the entirety of 2022, the VIX only rose by 21% and many market analysts critiqued the VIX by saying that it did not act as expected that year. Some even deemed it weird and questioned whether or not it is a good measure of investor sentiment amidst the market volatility in 2022. This is because, in light of the increasing uncertainty, the VIX was expected by many to surpass 40 but it did not, and it ended 2022 at slightly above the level of 23.
Is a High VIX Bullish or Bearish?
Extremely high VIX levels may indicate a bearish market sentiment with extremely high volatility. On the flip side, since the VIX looks forward, low levels may indicate a potentially bullish market ahead. Nonetheless, there’s no one-size-fits-all solution, and there’s no guarantee that the VIX will indeed lead to bullishness or bearishness in the markets.
Why Is the VIX Important?
The VIX is considered by many to be an important index, to investors and options traders alike, since it provides them with a sense of the anticipated volatility. Since volatility has a substantial role in determining options prices, the VIX may have a direct effect on the market as a whole.
What Happens When the VIX Spikes?
Stocks can indicate a positive reversal when VIX spikes more than 20% above their 10-day moving average line, according to an Investment Banking Division’s (IBD) study.
Take, for example, the all-time high the VIX achieved in 2020 as the CORONAVIRUS pandemic crushed many market sectors and increased fears and volatility. Accordingly, on March 18, 2020, the VIX topped out at 85.47, one point away from its peak price during the financial crisis of 2007-2008 at 89.53. At that time, many market selloffs materialized which only highlighted the intense fears market participants had then amidst the uncertainty arising from the novel virus strain.
What Does It Mean When the VIX Is up or Down?
When the VIX is down, there is less market anxiety, more stability, and longer-term growth. When the VIX is dropping, the S&P 500 tends to trade up. Along the same lines, when the VIX goes up, the S&P 500 generally tends to trade down and the market becomes more volatile. Traders should keep in mind that volatility does not always entail a weak market, as markets can trade down while volatility remains low.
Trading the CBOE VIX
Trading the CBOE VIX index can be done through Plus500 VIX Volatility Index (VIX) CFDs. CFDs or Contracts for Difference are derivative agreements between two parties stipulating that the difference between the open and closing prices of the underlying asset must be paid. CFDs allow traders to trade the VIX without actually owning it. This means that traders can trade on rising or falling VIX prices depending on their position. Traders and investors often use VIX-linked instruments for diversification and hedging, as well as for pure speculation, due to their strong negative correlation with the stock market.
What Is the Correlation Between the VIX and S&P 500?
There’s a negative correlation between the VIX and the S&P 500 in that when the VIX is trading higher the S&P 500 is usually experiencing a downtrend and vice versa. Similarly, the VIX tends to have a negative correlation with stocks.
This is why when traders know that an S&P 500 company may be trading down due to volatility, they can trade the VIX if they believe that this volatility will increase in the future in order to balance it out.
Conclusion
The VIX index is indeed a crucial gauge when it comes to the market and the overall sentiment. However, like many market instruments, the VIX also has its pros and cons, and those who believe that it might not be the best market sentiment index. Despite this, this is still one of the most referred indices when trying to measure volatility. Traders may trade the VIX with Plus500 VIX CFDs which allows them to potentially benefit from rising or falling VIX prices depending on their position without having actual ownership of the index. Nonetheless, traders should keep in mind that they can also incur losses if the price of the VIX goes against their position.
