Welcome to Alanis Business Academy.
I'm Matt Alanis and this is How the VIX Works
Due to market volatility, I thought it would be helpful to cover the commonly used measure
for gauging future expected market volatility.
This measure is known as the Chicago Board Options Exchange Volatility Index, commonly
referred to simply by its ticker symbol VIX.
So how does the VIX work?
Commonly referred to as the investor fear gauge, the VIX is constructed using implied
volatilities of a wide range of S&P 500 options.
As a way of producing a numerical value, the VIX uses a mathematical formula to analyze
the difference between the purchase of call and put option prices.
A call is a type of option contract that gives the owner the right to purchase a specified
number of a certain security at a set price for an established period of time.
Although the owner of the contract may exercise their call option if they wish, they are under
no obligation to do so.
So here is how it works.
Lets say that you purchase a call option to purchase 100 shares XYZ Company at $100 over
the next seven days.
XYZ Company is currently trading at $95 per share.
If you exercised your call option now you would be purchasing shares of XYZ Company
for $100 apiece while their market value is $95.
So essentially you are losing $5 per share, or $500 total if you purchase 100 shares.
So unless its share price increases over $100 there is no reason for you to exercise your
call option.
But if XYZ Company appreciates to lets say $105 per share, you can exercise your call
option and purchase shares for $100 each.
You can then turnaround and immediately sell them for $105 per share, which is the market
value, or you can simply put them in your portfolio.
Selling the securities immediately would yield a $5 per share profit or $500 total assuming
100 shares are purchased.
Now the only reason that an investor would by a call option is if they felt that the
market was going to appreciate value.
As a result, a greater number of call options compared to put options will lower the numerical
value of the VIX.
Now a put is another type of option contract that works in a similar fashion to a call.
However, instead of having the option to purchase a security, a put provides the owner with
the right to sell a specified number of shares at a specific price within a certain period
of time.
Think of a put option as like insurance on your home or vehicle.
Just like homeowners insurance and auto insurance, a put option is meant to protect you in the
case that your asset becomes damaged, or in this case decreases in value significantly.
If that does happen, you have a contract that gives the right to sell the security at a
higher than market value.
For example, lets say that you purchase a put option allowing you to acquire 100 shares
of XYZ company at $100 per share for a seven day period.
All of a sudden the share price of XYZ Company plummets from $105 to $90 per share.
Because you are the owner of a put option, you can exercise your option and sell your
shares at $100 per share instead of the market value of $90 per share, which would save you
quite a bit of money.
The only reason that an investor would purchase a put option is if they expected a security
to decrease in value and they either wanted to protect their own investments or take advantage
of investors who are not as vigilant.
Taking into account the basic economic principle of supply and demand, if investors purchase
a larger number of call options the the premiums or prices of those options will increase,
which will result in a lower VIX.
If investors purchase a larger number of put options than the premiums of those options
will increase, which will result in a higher VIX.
Although meaningless to some, this numerical carries significant importance to investors.
A score of greater than 30 communicates that a greater amount of volatility is expected
going forward and investors are overall more fearful.
A score of less than 20 communicates the expectation of low risk and low market volatility in the
future.
At least thats the expectation.
Due to the fact that the VIX is evaluating calls and puts that are purchased based upon
assumptions as well as expectations, the index measures the expectation of volatility and
not actual volatility itself.
So as with anything, there is always a risk of relying solely on one indicator to make
investment decisions.
This has been How the VIX Works?
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