The CBOE Volatility Index, otherwise known as the "VIX," is a popular indicator for investor sentiment on the stock market. It's a key barometer of investor fear and confidence and also a popular trading tool for options and equity traders, one widely used as a measure of market risk.
In the last couple of years, exchange-traded products have emerged allowing investors to profit from this volatility index, and thus offer a short-term hedge for stock portfolios.
The VIX was first introduced in 1993, and in March 2004, futures on the volatility benchmark began trading on the CBOE Futures Exchange. In January 2009, the first VIX-related ETF product began trading. Volatility-linked ETFs track VIX futures, rather than the spot price.
Essentially, the VIX helps illuminate how volatile investors believe the markets will be over the next 30 days, by measuring expected or implied volatility on large-capitalization U.S. stocks through the prism of options traded on the S&P 500 index. The VIX is based on the prices of a weighted blend of call and put options. As option premiums rise, the expectations about future volatility in the underlying S&P 500 index rise.
Generally, a high VIX reflects the spiking investor fear in the markets, and a low VIX shows investor complacency in a calm market. Historical data reveals that bull markets have generally corresponded with long-term lows in the VIX, usually under 20. It recently rose above 40. Probably not surprising given all the market volatility.
Understanding The VIX
Since the inception of the index, the VIX has quickly spiked upward during each market downturn, providing investors with a signal that the market bottom was nearing. The VIX tends to "revert to the mean" as gravity kicks in and markets become too oversold.
But investors should keep in mind that the VIX tends to show a negative correlation to the overall performance of the U.S. equities markets. That means people may use this contrarian investment tool to estimate market tops or bottoms on a short-term basis. High market volatility does not necessarily mean a market is bottoming out; however, it does signal extreme duress in the markets.
Making The VIX Work For You
Standard & Poor's has created two benchmark futures indices based on the VIX: the S&P 500 VIX Short-Term Futures Index Total Return and the S&P 500 VIX Mid-Term Futures Index Total Return. The short-term version maintains a constant one-month weighted average maturity by giving investors exposure to daily rolling long positions on first- and second-month VIX futures. The midterm index maintains a weighted average maturity of five months by offering exposure to daily rolling long positions on the fourth, fifth, sixth and seventh month VIX futures.
With the advent of futures-based exchange-traded funds and exchange-traded notes, the average retail investor is now able to gain access to VIX options. These exchange-traded products allow investors an innovative and efficient way to grab exposure in hard-to-reach niche markets.
The VIX as a trading tool offers opportunities in short-term hedging, speculation and even portfolio diversification. But they are not designed as buy-and-hold vehicles.