The Volatility Index
By Stephen Smith
August 5th, 2009
The Chicago Board of Options Exchange in 1933 introduced the Volatility Index (VIX), which was originally designed to measure the market’s expectation of thirty day volatility of the S&P 100 Index. In 2003, the Chicago Board of Options Exchange along with Goldman Sachs updated the Volatility Index (VIX) to reflect a new way to measure expected volatility, one that continues to be widely followed by financial theorists and volatility traders today. The new Volatility Index is based on the S&P 500 Index (SPX), the core index for United States equities, and seeks to estimate expected volatility by averaging the weighted prices of SPX put and call options over a range of strike prices.
The Volatility Index is regularly featured in many financial publications and business news programs and is also referred to as the “fear index.” Although the Volatility Index is called the fear index, a high Volatility Index is not necessarily bearish for stocks. Instead, the Volatility Index is a measure of fear. The Volatility Index is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 Index over the next thirty day period, on an annualized basis. For example, if the Volatility Index is trading at fifteen, this represents an expected annualized change of 15% over the next thirty days. One can infer that the Volatility Index option markets expect the S&P 500 to move up or down 1.25% over the next thirty day period.
The Volatility Index is interpreted as a measure of volatility in a certain sense, but it more accurately measures fear in the market place rather than volatility. That is why the Volatility Index is a sign of uncertainty. Between 1990 and October 2008, the average value of the Volatility Index was 19.04. The lowest reading was 9.31 on December 22, 1993, and the highest reading on an intra-day reading was 89.53 on October 24, 2008. The Volatility Index is currently trading around 24.50. Clearly we are not trading at average levels but the Volatility Index has come down dramatically from its 2008 highs. This indicates that fear is leaving the United States equity markets.
