How to Interpret Volatility Index (VIX)

The Chicago Board Options Exchange (CBOE) is the busiest and largest options exchange and creator of listed options in the United States.  In 1993, the CBOE introduced the technical indicator Volatility Index (VIX). 

VIX stands for Volatility Index.  It was originally invented to gauge the near-term (30 days) volatility tracked by the S&P 100 stock index option prices.  Technically, the volatility index gauges the implied volatility for a pool of put and call options associated with a particular index or ETF, which includes Indices (the S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite), and ETFs such as Gold SPDR, the USO Oil Fund, and the Euro currency Trust, etc.  In 2003, CBOE teamed up with Goldman Sachs and modified the VIX using a new methodology. 

The VIX is measured in percentage points and is annualized.  The VIX is based on a new methodology which facilitates investors and traders with the weighted 30-day standard deviation of annual movement in the S&P 500. 

A reading of a certain percent (such as 30%) means there will be a 30% volatility in the market within the next 12 months. This annualized number can be transformed into a monthly number by dividing it by the square root of 12, and daily number by dividing it by the square root of 252, which is the total number of trading days in a year. Top 5 Technical Indicators for ETF Trading discloses how to translate the VIX percentage into expected daily or monthly volatility.

Please note that the expected volatility refers to implied market fluctuation. It is not associated with return.  If the VIX changes in a positive way, the market is expected to increase volatility, and fluctuate more. Likewise, if the VIX is reduced, a less volatile and more stable market should be anticipated within the next 30 days.  One more thing, the 30 days are natural days instead of just trading days.

On 4/15/2013, the S&P 500 dropped 36 points, with a level not seen since last November.  Quite a few unexpected events occurred on that day. There was the Boston Marathon explosion, China missed its GDP expectation, home builder sentiment fell for the 3rd month, and gold futures dropped 10% as well.  The VIX skyrocketed 43%. This level is not often seen in a bull market.  The percentage surge in the VIX at 43%, according to the interpretation of VIX, is equivalent to about 12% of expected monthly volatility, and 2.7% of expected daily volatility in the next 30 days. 

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