The Cboe Options Exchange calculates a real-time index to show the expected level of price fluctuation in the S&P 500 Index options over the next 12 months. Officially called the Cboe Volatility Index and listed under the ticker symbol VIX, investors and analysts sometimes refer to it by its unofficial nickname: the fear index.
Technically speaking, the Cboe Volatility Index does not measure the same kind of volatility as most other indicators. Volatility is the level of price fluctuations that can be observed by looking at past data. Instead, the VIX looks at expectations of future volatility, also known as implied volatility. Times of greater uncertainty (more expected future volatility) result in higher VIX values, while less anxious times correspond with lower values.
The initial VIX was released by Cboe Global Markets in 1993. At the time, the index only took into consideration the implied volatility of eight separate S&P 100 put and call options. Following 2002, Cboe made the decision to expand the VIX to the S&P 500 in order to better capture market sentiment. VIX futures were added in 2004 and VIX options followed in 2006.
VIX values are quoted in percentage points and are supposed to predict the stock price movement in the S&P 500 over the following 30 days. This value is then annualized to cover the upcoming 12-month period. The VIX formula is calculated as the square root of the par variance swap rate over those first 30 days, also known as the risk-neutral expectation. This formula was developed by Vanderbilt University Professor Robert Whaley in 1993.
Investors, analysts, and portfolio managers look to the Cboe Volatility Index as a way to measure market stress before they make decisions. When VIX returns are higher, market participants are more likely to pursue investment strategies with lower risk.
"...it forces us to do what we know we're supposed to do as investors, which is, add low, trim high, a version of buy low, sell high. And often when left to our own devices, we don't do that. We let the winners run. They become an outsized portion of the portfolio. And when the inevitable reversion of the mean happens, you're holding a much heavier bag than you otherwise would have," said Liz Ann Sonders, managing director & chief investment strategist of Charles Schwab. "It's really simple, basic stuff, but it's so important to hammer home, especially when you have all these rotations, which frankly give you more opportunity to use volatility to your advantage via that process of rebalancing."