By Ee Hsin Kok. Edited by Arjun Chandrasekar.
Overview
VIX, which stands for the CBOE’s Volatility Index, is a real-time index that measures the volatility of the market. Often referred to as the fear index, it was introduced in 1993 and has since been used as a great way to gauge market sentiment. In this article, we go over how you can use the VIX to benefit you in your investment journey.
How It Works
The VIX is a forward-looking index. In fact, its job is to calculate a 30-day projection of volatility. It does this by performing calculations based on the implied volatilities of S&P 500 options. We’re not going to go into the math of how, because the formulas are incredibly complex, and we don’t actually need to. All you really need to understand is that the VIX uses volatility on options to determine market sentiment. High VIX values mean that people are becoming more fearful in the market, while lower VIX values mean people are becoming more confident.
Correlation between VIX and the Market
As of today (8/28/21), the VIX sits around 16 and has been hovering around this range for the last few months. Generally speaking, a VIX value above 20 is considered high (meaning there is fear in the market), while a VIX value below 12 is considered very low (meaning there is a lot of optimism). Meanwhile, a VIX value between 12 and 20 is pretty normal, which is the case now.
Historically, this has also meant that when prices fall in the market, the VIX tends to increase, and when prices rise, the VIX decreases. In other words, the VIX and the S&P 500 have a negative correlation. As you can see in the charts below, when the S&P 500 crashes, the VIX spikes. And when the S&P 500 rebounds, the VIX tends to fall again.
The VIX:
The S&P 500:
Trading the VIX
Given that the VIX moves in the opposite direction of the market, many investors use the VIX to hedge their portfolios against the possibility of a crash. However, one cannot directly buy the VIX index. Instead, the VIX is traded through derivatives such as options. So what some investors do is buy a 30 or 40-day out-of-the-money call option (which can be pretty cheap), and that call option would cover some of their potential losses should the S&P 500 drop within that time frame. And if the market isn’t looking like it is going to drop, when there are about 15 to 20 days left to expire on the call option, many investors will either sell that call at a slight loss or roll the call back so as to preserve their insurance.
Conclusion
In this article, you learned what the VIX index is, how and why it moves, and a basic way you can use it to hedge your portfolio against market drawdowns. So try it out, spend time analyzing the relationship between the VIX and the market, maybe even buy a few cheap out-of-the-money calls, because it can make for a very useful tool in the future!
