CBOE Volatility Index (VIX) - Explained
What is the CBOE Volatility Index?
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Table of ContentsWhat is the CBOE Volatility Index (VIX)?How Does the VIX Work?How Volatility is MeasuredExtending Volatility to Market LevelEvolution of VIXAcademic Research for VIX - CBOE Volatility Index
What is the CBOE Volatility Index (VIX)?
The CBOE Volatility Index (CBOE VIX) is a measurement of the 30-day expected volatility of the US stock market. This index measures the possible future volatility in the stock market in the period of 30 days. This index was created by the Chicago Board Options Exchange (CBOE), it is otherwise called the "Fear Gauge" or "Fear Index." The Volatility Index is arrived at using price inputs and options prices on the S&P 500 Index. VIX is an important metric that helps investors gauge market risk and volatility over a period of time. Below are the key points to know about CBOE VIX;
- The CBOE Volatility Index, otherwise called VIX, is a market index that represents market volatility over a period of 30 days.
- VIX derives is an index from the price inputs and options prices on S&P 500.
- This index also measures the future volatility of the market. Investors can evaluate market risk or volatility through VIX.
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How Does the VIX Work?
In the context of financial instruments such as stock, volatility refers to changes in price over a period of time. When the trading price of a security is unstable, thereby fluctuating frequently over a period of time, such security is volatile. Volatility Index measures the degree and frequency of price changes of a financial instrument. In addition to changes in the price of a financial instrument, VIX also measures changes as they occur in the market. VIX measures the future volatility of a particular market by checking the frequency of price changes or movement of prices over a period of time. When price changes rapidly, higher volatility occurs as against when price movement is less frequent
How Volatility is Measured
There are two different methods of measuring volatility, one is by calculating the historical prices of a financial instrument over a period of time while the other method entails using option prices to gauge volatility. In the first method, a statistical calculation of historical prices is done, in which the mean, variance and standard deviation of the data set are arrived at. The result of the calculation, reflexively with focus on the standard deviation is used to measure volatility. In the second method, the market value of a derivative instrument is inferred from the option prices. Hence, changes in option prices symbolize a change in the value of the underlying security. When the changes become frequent, volatility occurs.
Extending Volatility to Market Level
Volatility does not only affect financial instruments or investment vehicles, it also affects the entire market. In the actual sense, volatility measures the level of risk associated with a particular sector or market as seen in the security. The S&P 500 is an example of index that measures volatility as it occurs in the larger market. It is the leading indicator of the broad stock Exchange market in the United States. The Chicago Board Options Exchange (CBOE), thereafter created the CBOE Volatility Index as a benchmark to measure the possible future volatility in a market over a period of 30 days. This index draws data and inputs from the existing S&P 500 in order to arrive at a quantitative measure of the expected market volatility using a 30-day period. VIX is a recognized index used in gauging the vU.S. equity market volatility. .
Evolution of VIX
The CBOE Volatility Index was established in 1993 as an index that measures the expected market volatility over a period of 30 days. When it was created, VIX derived data from the inputs of options price in S&P 500. In 2003, given the level of maturity in the derivatives market, the Chicago Board Options Exchange (CBOE) updated VIX paving way for a different method of calculation. CBOE partnered with Goldman Sachs to improve on the existing index. The expansion of the CBOE Volatility Index opened up a channel to an accurate calculation of expected future market volatility.