Watching The VIX

June 25, 2006

An introduction to the CBOE Volatility Index: What it is, how it's calculated, and what it tells us about the market.

The market has been bouncing up and down these past few months as investors scurry around and jockey for position ahead of changes in the Fed's interest rate policy. Describing the market, commentators refer to the VIX, so I want to explain this index in more detail.

The VIX is the symbol for the Chicago Board Options Exchange (CBOE) Volatility Index. It has been published since 1993, although a few years ago its underlying calculations were updated.

The VIX measures the price of short-term options on the S&P 500 index and moves higher or lower as the options' prices increase or decrease. Over the years the index has ranged from about 10 when options are cheaper to over 40 when they are very expensive.

One reason investors follow the VIX, often called the "Fear Index," is because it moves up and down with investor uncertainty. Anxious investors are willing to pay more for options to protect their investments and thus the VIX will move higher.

The VIX has been very calm for the past few years and spent the early part of 2006 in the lower end (10 to 14) of its long-term range. In May, uncertainty crept into the market and it started to move higher - last week it reached a high of almost 24. It has backed off this week and is around 15.

So how does the VIX work? The actual calculation is complicated, but after a few definitions are covered, it can be described in relatively simple terms. For example, look at the price of a put option on the S&P 500 index and assume the index is at 1250 and the option's strike price is also 1250.

First, a put option gives the owner the right, but not the obligation to sell the underlying index at an agreed upon price (the strike price) until the option expires. In our example, the strike price is 1250, so if the index is below 1250 at expiration, the owner will exercise his put and sell the S&P 500 at 1250. If the index is above 1250, the owner of the put will obviously not want to sell below what he could get in the open market and therefore, he will just let the option expire worthless.

 

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