Volatility Index, known also as the VIX, was introduced by the Chicago Board Options Exchange (CBOE) in 1993 and later was revised in 2003 when the underlying securities was changed from S&P 100 Index to S&P 500 Index.
The CBOE describes the VIX as a key measure of market expectations of near-term “volatility” conveyed by S&P 500 stock index option prices. Put simply, the VIX measures the degree to which investors think stocks will swing vigorously in the next 30 days.
The VIX tends to surge on days when the market is expected to have significant swings, either plunging or skyrocketing. Put another way, the higher the VIX, the less investors know about where the stock market is headed. Nonetheless, a rising VIX is usually regarded as a sign that fear (bearish), rather than greed (bullish), is ruling the market. Hence, the VIX is often referred to as the "fear index”. The VIX falls on days when stock prices are stable.
The VIX index is calculated from the price of options linked to the S&P 500 stock-market index. Specifically, The VIX calculates the “expected” stock market volatility for the next 30 days by using a weighted average of “implied” volatility from S&P 500 index options contracts having the two months closest to expiration. Thus, the implied volatility reflects the expected price range of the underlying S&P 500 index.
The volatility index is more than just a fear index. Investors are able to trade futures contracts and option contracts written on the VIX, by betting against the index's own movements. The VIX derivatives provide investors a way to hedge against volatility in the stock market.
VIX futures began trading on March 26, 2004, on the CBOE Future Exchange. Meanwhile, VIX options were launched in February 2006.
An option is a contract that gives an investor right to buy or sell a security at a certain price at a certain date. These contracts are similar to insurance policies in case big moves in the market cause trouble in a portfolio. Like insurance, an option contract costs money, in term of a premium, whose price can fluctuate.
Volatility is just a statistical term to measure the tendency of the market to fluctuate, either a lot or a little. Big fluctuations suggest fear, because they mean that investors are frantically changing their minds about what stocks are worth in the face of great uncertainty. Smaller fluctuations suggest that investors are confident that they know what stocks are worth due to greater stability.
Option prices reflect the volatility that investors expect in the market, because volatility is one of the factors used to calculate the value of an option contract. Therefore the price of call options and put options can be used to calculate “implied” volatility.
Higher volatility of the underlying security increases the price of an option contract, because there is a greater likelihood that the option contract will expire "in the money". When an option contract is “in the money” at expiration, a buyer can exercise his right to buy (in the case of a call option) or sell (in the case of a put option) the underlying stocks (or index) at a fixed price. Otherwise, he can let the option contract expire worthless. Obviously, if a trader can buy stocks for less than their current price or sell them for more than their current price, he will do so.
Since options pay off when the underlying stock (or index) makes big moves, option buyers are willing to pay more when they expect lots of volatility on the underlying securities. In other words, the more volatile a stock price is, the higher options contract price is going to be. Simply put, they expect to exercise their options contracts at expiration. In a falling market, buyers are essentially betting on a further decline.
In the case of the VIX, option buyers are fearful that the S&P 500 index is going to have more large swings over the next 30 days. Therefore, they are paying more for options contracts on the S&P 500 index. When option prices get inflated by expectations of high volatility, the VIX goes up, other things being equal. When options prices are deflated by expectations of low volatility, the VIX goes down.
The VIX is a measure of fear of volatility in either direction, to the down side or to the upside. Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. The VIX will be low only when investors perceive neither significant downside risk nor significant upside potential.
The percentage point reading of VIX is what a statistician would call the "forecasted annualized standard deviation of returns" and is translated as the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis.
A VIX reading of 40 represents an expected annual change of 40 percent; or over the next 30-days, S&P 500 index is expected fluctuate within a range of plus or minus 11.55 percent. In the other word, the index options are priced at expected 11.55 percent gain or loss of the S&P 500 over next 30-day, with a 68 percent likehood.
A VIX reading of 20 would mean expected volatility of the S&P 500 is less, staying within 20 percent standard deviation, or within a range of plus or minus 5.77 percent over the next 30-day period.