Volatility, The Importance Of The Vix Index In Trading
The VIX index should not be understood as “fourteenth” but as the Chicago Board Options Exchange Volatility Index. Before we can describe it, we must necessarily review the concepts of “index” and “volatility”.
What is an Index? What is Volatility?
The index (or more technically “index number”) is a number that expresses the variation in the intensity of a given phenomenon in different circumstances. For example, in finance, “price indices” indicate the level of certain prices in a geographical area. Their importance is also associated with the exact moment when they occur, since in finance it is important to take account of all price movements over the whole time period, for statistical and mathematical purposes.
Volatility expresses the percentage change in a price of a financial instrument over a given period: the stronger the price change over a given period, the higher the volatility, the weaker the price change, the lower the volatility.
The Importance of VIX in Online Trading
At this point, having clear these two concepts, we can resume the discussion on the volatility index VIX. This is calculated by the world’s largest options market since 1983 and measures the implied volatility of the option price. Its function is to measure the price that market participants have negotiated to pay to buy options on the S&P 500 index. An option is defined as the option without obligation to bet on the upside and downside of the Standard & Poor’s 500 index.
It is therefore not the general concept of volatility, but the volatility of a particular market, on a particular index, on a particular instrument. But why do you associate the volatility of the option with that of its underlying? Why is this index so important for the trading environment?
Well, since options are based on an underlying, i.e. a financial instrument, the volatility on a particular option can only derive (as it is derived!) from the price of the underlying itself.
When we talk about volatility we can refer to two moments in time: the past and the future. Which force is more interesting from an investment point of view? Obviously the future. Well, in the volatility index there are some very interesting technical factors that in addition to the immediate situation, take into account historical data, so the impact of volatility on a given index in certain situations. These are implicit estimates that are also relevant to the expected volatility. Therefore, to summarize, the expected volatility is given by the historical volatility data applied to the immediate volatility.
The VIX index, ultimately, is an index that measures the expected volatility of the S&P500 index.
Comparison Between VIX Index and S&P 500 Index
In this illustration, we highlight the comparison between the VIX index and the S&P500 index.
As you can see, when implied volatility sees an increase, the S&P500 index tends to fall. It is very interesting and it is also very evident why this index bears the nickname of “fear index”. The VIX index is in fact basically an index that also measures the confidence of the market, of investors, and this phenomenon (VIX rise → S&P fall) can be explained by the tendency of falls to have more “violence” than rises.
Dynamics of VIX
On the markets it is easy to observe this phenomenon, so much so that operators cause the share price to rise. In fact, it can be said in the norm that:
- VIX equal to or less than 20 indicates a predominantly bullish situation.
- VIX in the interval between 20 and 40 indicates a tense but certainly not bearish phase.
- VIX above 40 indicates a highly volatile situation, with high downside risks.
Confirmations to VIX’s Thesis
This trio of predictions in the past has worked very well and there have been several confirmations of its support. In 2008, for example, there was a huge drop in the S&P500 index, while just before that the VIX index had reached 80! In 2012, the VIX index returned below 20 points and there was a strengthening of the American economy (we repeat once again that the VIX measures volatility on the S&P500 index). In the last few years, i.e. since the end of 2013, the trend has seen very short peaks at altitudes close to 20 and then between 2014 and 2015 at levels never seen before, in the positive sense for the S&P 500 index.