How to Understand the VIX

Volatility index

VIX is short for volatility index. It is constructed using the volatility from the Chicago Board Options Exchange (CBOE) and a range of S&P 500 call and put options. While the index is based on historical volatility data, it is meant to be a forward-looking calculation, which means it is meant to help traders forecast the future direction of the market. The best way to understand VIX is to understand its components and the variables which drive those components.

Instructions

1. Understand what a call is. A call is the right, but not the obligation, to purchase an asset in the future at a predefined price referred to as the strike price.

2. Understand what a put is. A put is the right, but not the obligation, to sell an asset in the future at a predetermined strike price.

3. Review the three different variations of the index. The VIX tracks the S&P 500, VXN tracks the Nasdaq 100, and the VXD tracks the Dow Jones Industrial Average.

4. Review the main drivers of option pricing. Calls and puts are financial assets which give the holder the option to make a transaction in the future; however, the transaction is predicated on the price of the underlying asset. If the underlying asset has a good amount of price movement (volatility) the value of the option (call or put) goes up as the strike price has a higher probability of being hit.

5. Interpret VIX values. A VIX over 30 is generally associated with large amounts of volatility from market uncertainty, and a value less than 20 is indicative of a neutral market environment.

References

• Investopedia: VIX

Resources

• Read this Article in Spanish