High inflation, doubts about growth and the potential impact of the war between Russia and Ukraine are just some of the factors that have brought uncertainty back to the markets, pushing up the most famous fear index: the VIX. Launched by the Chicago Board Options Exchange (CBOE) in 1993, the index measures market expectations about future volatility. The trend of this index therefore allows us to assess the level of market uncertainty. In this article we explain what it is, what it is for, how it is calculated and how the markets react when there is a sharp increase.

To explain what the VIX is, we must first focus on volatility. Why is it so important to keep it under control or know how to exploit it? Volatility measures the frequency and extent of price changes, both upwards and downwards, recorded by a financial instrument over a given period of time. More pronounced fluctuations correspond to a more volatile market environment. We can calculate volatility ex post, based on historical price data (and therefore we are talking about realized volatility), but we can also analyze the volatility implied by option prices to predict future movements. And it is in this context that it is worth observing the performance of the VIX.

What is VIX

The VIX, also known as the fear index, was created in the 1990s by the CBOE, one of the most famous stock exchanges in the world. It is the first benchmark index that measures market expectations about future volatility. For this purpose, it uses options on the S&P 500 index as underlying, with which it has a negative correlation: if the S&P 500 rises, the VIX falls, and vice versa. It is because of this near-perfect negative correlation and asymmetrical profile that the VIX takes on particular importance when making an investment decision.

How is it calculated

The VIX estimates expected volatility by aggregating the weighted prices of call and put options on the S&P 500 (SPX). In other words, it expresses the weighted average implied volatility of a basket of 30-day options on the S&P 500. This is a simplified definition, as the methodology for calculating the VIX (available on the CBOE website) is quite complex.

How to use

We come to the key question: what is the fear index really for? The VIX serves as a barometer of market uncertainty and gives investors an estimate of the 30-day steady volatility expected by the market. It is therefore a risk indicator. Specifically, the VIX index reflects the temperature of the American stock market, but there are similar indices that perform the same function on other markets: for example, that of the European market is called VSTOXX. Furthermore, the VIX methodology is also employed for other assets such as bonds, currencies etc.

The availability of a wide range of VIX indices provides investors and all market participants with a vast arsenal of tools for assessing what is currently implied by implied volatility. In other words, it provides clearer indications of what the market expects about the future path of realized volatility.

How the market reacts to a sharp increase in the VIX

The sharp movements recorded by the stock markets with the outbreak of the war between Russia and Ukraine pushed the VIX to 32 points, “a level far above the average of 19 points recorded from 1990 to today and the value of 17 points at the beginning of the year” explains Duncan Lamont, CFA, head of strategic research at Schroders. The expert points out that, contrary to what one might think, when the index rises to levels not seen for some time it tends to be a rather reliable indicator of the future evolution of the American stock market.