Volatility Index (VIX)

What is Volatility and
Volatility index?

Volatility is an indicator of the various fluctuations a specific stock price can have, a sector-specific index, or a market-level index makes, and it represents the risk levels associated with the particular security, sector or market. Volatility is a census enumeration of the spreading of returns for a given security or market index. In most cases, the higher the volatility, the more risky a security is. Volatile assets are considered riskier than less volatile assets because the price is more unstable, thus more difficult to study and predict. Since, volatility is an important variable for calculating securities prices, knowing how to measure volatility is of essential importance when trading in the security market or index market. One could also define volatility as the fear index and investors sentiment index in the financial markets.

How to measure volatility?

Volatility represents how large an asset's prices swing around the mean price - it is a statistical measure of its dispersion of returns. There are several ways to measure volatility which include option pricing models, standard deviations of returns and beta coefficients. Volatility is often measured as either the standard deviation or difference between returns from that specific security or market index. In the securities markets, volatility can be frequently associated with big movements in either direction.

For example, when the stock market rises and falls more than one percent over a sustained time period, it is called a volatile market. An asset's volatility is a key factor when pricing options contracts. We can say that volatility is a movement of more than one percent over a certain period of time, which is a key factor when pricing options contracts of an asset.

How does volatility work?

Volatility aims to calculate the magnitude and price size movements that a n asset experiences over a certain period of time. The higher the price swings are in that asset, the higher the level of volatility, and vice versa. Thus, volatility in the stock market can be used as a tradable asset. The main two driving forces of the stock market volatility are supply and demand, placing index trading amongst the most distinct volatility performers in the markets. As there is more supply on shares than buyers are willing to accept, the depreciation in price may accelerate as market psychology turns pessimistic. A sell-off occurs when a considerably large volume of securities or stocks are sold in a short time period, causing the price of a security or stock to fall rapidly.

The economic situation of the countries involved, in addition to geopolitical risk and instability can undoubtedly affect trade, financial flow and consequently interest rates. Events such as the current pandemic, official speech of the president of a central bank can either positively or negatively impact the value of currencies, indices and assets in general. An unfortunate event of a turmoil between countries could be a serious force to shake the markets. When a currency’s supply is greater than its demand most likely will decrease its value and vice versa. When demand is greater than supply then the value of the currency will most probably increase.

How to calculate volatility?

We can measure volatility using two different ways. The first method is based on performing statistical calculations on previous close (historical previous close price) over a specific time period. This process involves calculating several statistical data and numbers, like mean (average), variance, and finally the standard deviation on the historical price data and market data sets. The resulting valuation of standard deviation is a measure of risk or volatility. Volatility is often calculated using variance and standard deviation. The standard deviation is the square root of the variance. For example, we assume we have 30 days (monthly) stock closing prices of 10USD through 100USD. We assume, month one is 10USD, month two is 20USD, and so on. The standard deviation method is based on lots of speculations and most of the times it cannot be considered as an accurate measure of volatility. Because of the fact that this calculation is based on past prices and performances, the resulting figure is called “historical volatility” or “realized volatility”. To predict future volatility for the next months, an ideal approach is to calculate it for the same number of past recent months and expect that the same formula is more likely to repeat itself in the near future.

The second method for volatility measuring involves deducting its value as implied by option prices. The strike price or exercise price are actually options (derivative instruments) whose price depends upon the chances of a particular stock’s current price moving towards a particular level. For example, say Pfizer Inc. stock is currently trading at a price of 37.17USD per share. There is a call option on Pfizer with a strike price of 42.50USD and has one month to expiry. The price of such a call option will depend upon the market perceived probability of Pfizer Inc. stock quotes moving from current level of $37.17 to above the strike price of USD42.50 within the one month remaining to expiry. Several option pricing methods like the Black Scholes method which includes volatility as a fundamental input framework. Option prices can be used to obtain the price fluctuations of the underlying security of Pfizer Inc. in this example. Such volatility, as implied by or inferred from market prices, is called “implied volatility” or “forward-looking”.

Though none of the aforementioned methods is accurate as both have their own advantages and disadvantages as well as varying underlying speculations and assumptions, giving similar results for calculation that lie in a narrow range.

  1. Mean (average price) à of the data set. Add each value and then divide them by the number of values. If we add, 10USD, plus 20USD, plus 30USD, all the way to up to 100USD, we get 550USD. This is divided by 10 because we have 10 numbers in our data set. This provides a mean, or average price, of 55,00USD.
  2. Deviation à Calculate the difference between each data value and the mean. We take 100USD - 55.00USD = 45.00 USD. Then 90USD - 55.00USD = 35.00USD. This continues all the way down to the first data value of 10USD. Since we need each value, these calculations are frequently done in a spreadsheet. Negative numbers are allowed.
  3. Square the deviations à To eliminate negative values.
  4. Add the squared deviations together.
  5. Divide the total of the squared deviations by the number of data values.

Investors frequently use standard deviation, as price returns data sets often resemble more of a standard distribution, bell curve.

How to extend volatility to
market level?

In the world of investments, volatility is an indicator of the move sizes of a stock price, an index of a specific sector, or a market-level index, and it represents how much risk is associated with the specific security or market sector. It is also considered to be a risk and fear chart.

What makes the comparison of possible price fluctuations and all the risk associated with different securities and market sectors is to have a standardized quantitative measure of volatility. The VIX Index is the first benchmark index introduced by CBOE to measure the market’s speculative expectations of future volatility. It is constructed using the implied volatilities on S&P 500 index options (SPX) and represents the market's expectation of 30-day future volatility of the S&P 500 index which is considered the leading indicator of the broad U.S.

Being a forward-looking index, VIX Index Values are calculated using the CBOE standard SPX options (expiration on the third Friday of each month) and using the weekly SPX options (expiration all other Fridays). It estimates the expected volatility of the S&P 500 index by gathering the weighted prices of multiple SPX puts and calls over a wide range of strike prices.

What is the VIX or the
Cboe Volatility Index?

Market volatility can also be seen through the VIX or Volatility Index. The VIX was invented by the Chicago Board Options Exchange – which is the use of volatility as a tradable asset and a well sophisticated financial instrument- as a measure to calculate and predict the 30-day expected volatility of the U.S. stock market. Using real-time quote prices of S&P 500 call and put options. More precisely, the CBOE volatility index observes and measures the degree of variation in their trading price over a time period, which is 30-day volatility. Back in 1993, VIX was calculated as a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options, when the derivatives market activity was still limited and still growing. A decade later - as the derivatives markets matured - in 2003, CBOE in a collaboration with Goldman Sachs had updated the methodology to calculate VIX in a different way. It then started using a wider set of options based on the broader S&P 500 index like the Dow Jones CBOE DJIA Volatility Index of Wall Street. This has helped investors around the globe to have a more accurate view of expectations on future market fluctuations and volatility.

How to trade the VIX?

The first VIX-based exchange-traded futures contract where introduced in 2004 by the CBOE, which was followed by the launch of VIX options a couple of years later. Like all indices, one cannot buy the VIX directly. Thus, instruments allow an absolute volatility exposure and have created a new asset group altogether.

These products offer a unique approach to protecting one's portfolio and making strategic bets on future market volatility. Thus, active traders, large institutions and hedge fund managers use securities associated to the VIX as portfolio diversification, as historical data shows a strong negative correlation of volatility to the stock market returns – that is, when stock returns depreciate, volatility rises and vice versa.

The ytd – 52 week range - is a data including the lowest and highest price at which a stock has traded during the previous this specific time period and is traditionally reported by financial news media like the Barron’s, Investing and Reuters and Forbes. Other than the standard VIX index, Cboe also offers several other variants for measuring broad market volatility.

Other similar indexes include the Cboe Short Term Volatility Index (VXSTSM), which mirrors the nine day expected volatility of the S&P 500 Index, the Cboe S&P 500 3 Month Volatility Index (VXVSM), and the Cboe S&P 500 6 Month Volatility Index (VXMTSM). Products based on other market indexes include the Nasdaq-100 Volatility Index (VXNSM), the Cboe DJIA Volatility Index (VXDSM) which is the Wall Street’s Dow Jones, and the Cboe Russell 2000 Volatility Index (RVXSM). Instead, investors can take a position in VIX futures or options contracts, or through VIX based exchange traded products (ETP) such as exchange traded funds (ETFs).

Active traders who employ their own trading strategies as well as advanced algorithms use VIX values to price the derivatives which are based on high beta stocks. Beta represents the move size of a particular stock price in regards to the move in a wider market index. Traders investing through options of such high beta stocks utilize the VIX volatility values in appropriate proportion to correctly price their options trades. For traders in equity, the VIX is a very good and sound measure of risk in the markets. It gives these intraday traders and short term trades an idea of whether the volatility is going up or going down in the market.

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Source - database | Page ID - 18303

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