When markets are bouncing around, market commentators will often focus on the S&P500 Volatility Index.
And while many investors and traders have no doubt heard of the VIX, it is often misunderstood as a historical record of what the S&P index has already done.
It’s important to first understand that the VIX is calculated through the options market, as such, it is a measure of the market’s implied volatility looking forward. Essentially, by looking at the pricing of the options that traders are paying for, the VIX demonstrates what traders believe that volatility will be over the next year.
How is it calculated?
The VIX is tracked and reported as an annualized number. So, to put the index into perspective, traders need to de-annualize the current level to determine an implied daily impact.
To do this, the index needs to be divided by the square root of the number of trading days in the year. Using a general rule of 252 days, the square root of which would be 16, traders can simply divide the VIX by 16 to determine an expected daily move.
If you have a VIX of 30 (divided by 16), this means the VIX is implying that the market will move by about 1.875% each day.
While a higher VIX of 40, would suggest that the market will shift by 2.5% daily.
Why is this significant?
When the VIX is implying that the market is being priced to move every single day at 2.5%, this extreme uncertainty means that investors essentially do not know how to price the market anymore.
This is why the market will often bottom when the VIX gets up to a high level as traders can expect anything, and as a result, will be willing to pay a very high premium to protect themselves from further downside.
While things can always become more extreme, as demonstrated when covid hit, sending the VIX to over 80 and implying the market would shift by 5% every day, the index provides a good way to understand what kind of environment traders and investors are working in. With this invaluable context, they may determine what kind of portfolio exposure is appropriate for their risk profile.