If you watch financial news, you have probably heard mentions of the VIX, often accompanied by dramatic language about fear and panic in the markets. But what exactly is the VIX, how is it calculated, and most importantly, how can you use it in your trading? Let us break it down.
What is the VIX?
The VIX, officially known as the CBOE Volatility Index, measures the market's expectation of 30-day volatility in the S&P 500 index. It was created by the Chicago Board Options Exchange (CBOE) in 1993 and has become one of the most widely watched indicators of market sentiment.
Simple version: The VIX tells you how much the market expects the S&P 500 to move over the next 30 days. A high VIX means traders expect big moves (usually down). A low VIX means traders expect calm markets.
Why is it Called the Fear Index?
The VIX has earned the nickname "fear index" because it typically spikes during market selloffs and crashes. When investors are scared, they rush to buy put options as protection. This increased demand for options drives up their prices, which in turn increases implied volatility and the VIX.
Here is the relationship:
- Market falls sharply: VIX spikes higher
- Market rallies steadily: VIX drifts lower
- Market is calm: VIX stays low
- Uncertainty increases: VIX rises in anticipation
How is the VIX Calculated?
The VIX is calculated using the prices of S&P 500 index options (SPX options). It uses a wide range of strike prices, both puts and calls, to derive the expected volatility. The calculation is complex, but here is what you need to know:
- It uses options with about 30 days to expiration
- It weights options across many strike prices
- It extracts implied volatility from option prices
- The result is annualized and expressed as a percentage
What VIX Numbers Mean
VIX at 15: The market expects the S&P 500 to move about 15% over the next year, or roughly 4.3% over 30 days (15 divided by square root of 12).
VIX at 30: The market expects about 8.7% movement over the next 30 days. This is elevated volatility.
VIX at 50+: Extreme fear. This has only happened during major crises like 2008 and March 2020.
Historical VIX Levels
Understanding typical VIX ranges helps you interpret current readings:
- Below 12: Extremely low volatility, often called complacency
- 12-20: Normal market conditions
- 20-30: Elevated fear, increased uncertainty
- 30-40: High fear, often during corrections
- Above 40: Extreme fear, major market stress
The long-term average VIX is around 19-20. The all-time high was 82.69 on March 16, 2020, during the COVID crash. The VIX has also spiked above 80 during the 2008 financial crisis.
The VIX and S&P 500 Relationship
The VIX and S&P 500 have a strong inverse correlation. When stocks fall, the VIX rises. When stocks rally, the VIX falls. This relationship is not perfect, but it holds most of the time.
There are some nuances to understand:
- Rallies are gradual: The VIX tends to drift lower during bull markets
- Selloffs are sudden: The VIX spikes quickly during crashes
- Fear is temporary: VIX spikes eventually mean-revert back to normal levels
- Complacency can last: Low VIX periods can persist for months
How Traders Use the VIX
1. Market Timing Indicator
Some traders use extreme VIX readings as contrarian signals. Very high VIX readings often occur near market bottoms, while very low readings can precede corrections. However, using VIX alone for timing is risky because extremes can become more extreme.
2. Options Strategy Selection
The VIX helps options traders choose appropriate strategies:
- High VIX: Favor selling premium (iron condors, credit spreads)
- Low VIX: Favor buying options (debit spreads, long calls/puts)
3. Portfolio Hedging
When the VIX is low, hedging is cheap. Smart investors buy portfolio protection (puts or VIX calls) when fear is low, not when it is already elevated. This is like buying insurance before the storm, not during it.
4. Volatility Trading
Traders can trade VIX directly through futures, options on VIX, or VIX-related ETFs. This allows them to profit from volatility movements without taking a directional view on the market.
VIX Products You Can Trade
There are several ways to gain exposure to the VIX:
- VIX Futures: Trade directly on CBOE Futures Exchange
- VIX Options: Options on the VIX index itself
- VXX: Short-term VIX futures ETN (note: suffers from contango decay)
- UVXY: 1.5x leveraged VIX futures ETF
- SVXY: Inverse VIX futures ETF (profits when VIX falls)
Warning: VIX ETFs and ETNs are complex products that do not track the VIX directly. They use futures, which creates roll costs and contango decay. These products are designed for short-term trading, not long-term holding. UVXY and similar products lose value over time even if the VIX stays flat.
Common VIX Trading Mistakes
- Buying VIX ETFs as long-term hedges: Contango decay destroys value
- Shorting the VIX during spikes: VIX can spike higher than you expect
- Using VIX as sole timing indicator: Low VIX can stay low for years
- Not understanding mean reversion: Extreme VIX readings do not stay extreme
VIX Futures Term Structure
VIX futures trade at different expirations, creating a term structure. Understanding this is crucial for VIX trading:
- Contango: Future months trade higher than spot VIX (normal condition)
- Backwardation: Future months trade lower than spot VIX (during fear)
Contango is the normal state about 80% of the time. This is why long VIX products decay over time. They must constantly roll from lower spot prices to higher futures prices.
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Practical Tips for Using the VIX
- Watch for VIX spikes above 30 as potential buying opportunities
- Buy hedges when VIX is below 15 (protection is cheap)
- Sell options premium when VIX is elevated
- Avoid holding VIX ETFs for more than a few days
- Use VIX as one input among many, not the sole decision factor
Summary
The VIX is the market's fear gauge, measuring expected volatility in the S&P 500 over the next 30 days. It spikes during market selloffs and falls during calm periods. Traders use it for market timing, strategy selection, and volatility trading. While powerful, the VIX should be used alongside other analysis, and VIX products require careful understanding due to their complex structure.
Learn more about how to trade the VIX or read about implied volatility.