What Is the CBOE Volatility Index (VIX)?

Investors who want to get a read on stock market sentiment can turn to the CBOE Volatility Index, or VIX, to interpret patterns of expected future volatility before making investment decisions.

The VIX is an index, not a financial instrument investors can buy directly. Investors can access the VIX through the purchase of futures contracts, exchange-traded notes or exchange-traded funds.

Both the iPath S&P 500 VIX Short-term Futures ETN (ticker: VXX) and the ProShares VIX Short-Term Futures ETF ( VIXY), for example, offer exposure to the S&P 500 VIX Short-Term Futures Index, which measures returns of VIX futures contracts within a 30-day maturity.

As a guide to scope out the level of panic in the markets, investors can monitor the VIX index to see if there are buying opportunities, adjust their investment strategy or make their next market move. Understanding the basic elements of the VIX could be helpful to factor into your analysis toolkit:

— What is the VIX?

— Using the VIX to guide investment decisions.

— VIX performance in 2020.

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What Is the CBOE Volatility Index?

Cboe Global Markets is a company that owns the Chicago Board Options Exchange and the stock market operator BATS Global Markets.

This exchange holding company, which offers trading and investment solutions for investors, created the CBOE Volatility Index in 1993. Since then, the VIX has become the chief benchmark index to measure the stock market’s expected volatility. Also referred to as the fear gauge, the VIX may capture investor confidence in the stock market.

Volatility is the fluctuation of financial instrument prices over a period of time; the more rapid an asset’s price movement, the greater volatility that asset is said to exhibit.

“The VIX reacts to drops in global stock markets as it measures the extent and speed of the fall,” says James McDonald, CEO and chief investment officer at Hercules Investments in Los Angeles.

“The greater the drop, the higher the jump in the VIX,” McDonald explains. “These jumps are spike-shaped as the VIX quickly reverts to its lows once new information flowing into the hands of market participants quells their fear and uncertainty and markets stabilize.”

The VIX index is based on options prices of the S&P 500 and captures investor sentiment of 30-day expected stock market volatility.

When the VIX rises, the market is experiencing volatility and there is increased fear among investors who have less confidence in the market in the short term. Keep in mind, the VIX represents expectations rather than what occurs in the market.

Through the VIX’s intricate formula, the index is calculated using real-time S&P 500 option prices and is determined throughout the day through S&P 500 bid and ask quotes. In the global markets, the VIX is recognized as the standard for market volatility, closely monitored by institutional and retail investors and extensively reported on in financial media to measure short-term market sentiment.

[See: 8 Best Vanguard ETFs for Retirees.]

How to Use the VIX to Help With Investment Decisions

Broadly speaking, investors can review the VIX and make a quick judgment on how the stock market is behaving or set to behave in the short-term future.

Investors can estimate the scale of future volatility by considering economic and political stability, company earnings and notable federal announcements. These observations can serve as an accessory element in your investment decision-making rather than a determining factor because the VIX could overstate future volatility.

If the VIX index level is below 12, volatility is said to be reduced. A VIX level of more than 20 is high, and anything in between can be seen as normal, according to S&P Dow Jones Indices.

When investors observe rising VIX levels, this can be an opportunity to take advantage of defensive investing strategies. Long-term investors can use the VIX as a measure of fear, says David Russell, vice president of market intelligence at TradeStation in Chicago.

“When it’s rising, correlation increases. That means stocks follow the broader market more closely and fundamentals might get disregarded at the individual company level. Investors may want to focus on broad index funds when the VIX is high. Once it falls, individual stock picking can be more effective,” he explains.

Broad index funds like the Fidelity 500 Index Fund ( FXAIX) or the Vanguard 500 Index Fund ( VFINX) provide diversification and offer low fees by tracking the S&P 500. While it makes sense to have a more defensive strategy in a recession to protect your portfolio, we are also in a low interest rate environment, leaving fixed-income investors hungry for higher yield.

Studying the VIX can help investors gauge the level and magnitude of market volatility. By monitoring the direction of the VIX, investors can make predictions on where the market is headed and ultimately decide how to hedge their portfolio risk.

An investor who follows the VIX will have a better understanding of the volatility environment, which will better enable them to react, or not react, appropriately, says Elizabeth Skettino, options strategist at Wells Fargo Investment Institute in Charlotte, North Carolina.

“For example, in a low volatility year like 2017 where the average VIX level was 11, implying a one-day move of 0.69%, a day on which the S&P moved 1% would be noteworthy and may signal trouble ahead. In contrast, in a year like 2020 where the average VIX level is close to 30, implying a 1.9% daily move, a day on which the S&P moved 1% is practically a boring day,” Skettino explains.

[SEE: 10 Momentum Stocks Millennials Are Buying in Q4.]

VIX Performance in 2020

There have been several drivers of market volatility in 2020.

The beginning of the year started with the pandemic, which impacted how we interact and work by forcing us to live more isolated lives.

All of these changes affected the performance of certain market sectors, ultimately leading to a pandemic-induced recession. There were areas of the economy that thrived while businesses that depend on human interaction, such as entertainment, travel and leisure, have been fundamentally impacted or have altogether shuttered, resulting in high levels of unemployment.

These unprecedented events spurred high levels of uncertainty. In January and most of February, the VIX reading was at normal levels, ranging around 12 to 15, with pockets of increases. In March, the VIX experienced a steep spike — reaching its highest level of 82 in mid-March after the S&P sank 12%. The last time the VIX hit that high of a reading was in November 2008. Since then, the volatility index has come down in October, but it’s still higher than normal levels, hovering in the high 20s.

“2020 has certainly posed a unique set of circumstances that have been keeping volatility elevated, namely, the unpredictable path of the virus, the economic fallout from lockdowns and changing nature of the post-COVID economy, and the looming U.S. election,” Skettino explains.

Inflated volatility has alarmed investors as to where and how they invest their money, or to take it out of the market altogether.

Current higher-than-normal VIX levels are in large part due to being in a year of a contentious presidential election. But Dan Passarelli, CBOE veteran and president at Market Taker Mentoring in Chicago, says that looking back over the past 10 years, it’s the norm that the VIX rises going into the election. “When we look at the VIX term structure, it’s clear there’s some anxiety built into this election,” he says.

“In 2016, the VIX didn’t rise until a couple of weeks leading up to the election, going from 14 to 27. Now, we’re more elevated than a typical election cycle where the market is perceiving higher than normal volatility leading up to the election but even higher volatility following the election,” observes Passarelli.

With the presidential election less than a month away, Skettino anticipates the VIX to be even higher than current levels with election results that may not be decided on the same day or week. “VIX has been holding firm in the high 20s and the VIX futures curve shows even higher volatility in the post-election period, reflecting the potential for delayed results due to mail in voting,” she says.

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What Is the CBOE Volatility Index (VIX)? originally appeared on usnews.com

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