By Sahil Bloom:

If you follow the financial news, you’ve probably heard a lot of talk recently about the VIX. But what is the VIX and how does it work?

The Volatility Index (“VIX”) was created by the Chicago Board Options Exchange as a real-time market index representing the market’s expectation of 30-day forward-looking volatility. It is often referred to as the “Fear Index” by investors. Let’s take a look at how it works.

Volatility measures the magnitude of price movements (up and down) over a set period of time. Historical volatility is based on actual historical price movements. Forward-looking volatility (“implied volatility”) is inferred based on option prices. The VIX infers its value by tracking the pricing of S&P 500 index options.

But what do S&P 500 options prices have to do with investor fear?

When investors expect stock prices to make a significant move (up or down), they typically purchase more options to protect themselves against those movements. Think about it as buying insurance to protect your home if you’re expecting an earthquake to hit soon. So in an environment where investors expect a big near-term price drop, it is reasonable to expect a surge in demand for put options. There is more uncertainty in the market, so investors seek protection via these options. Demand for them rises. If demand rises quickly, supply will not have a chance to catch up.

Econ 101 tells us that the price of the options must rise. Since we know the VIX tracks the pricing of S&P 500 index options, we can see the relationship form. S&P 500 put option prices spike = VIX spike.

To use a real example, the VIX spiked to a peak of >80 in mid-March, as fears of COVID-19 damage peaked. It has steadily declined since, as Central Banks worldwide have eased investor fears. Typically, VIX values <20 correspond to stable, low-stress periods in the markets.

Since the VIX is an index, you cannot trade it directly. But this is finance, so interested investors can speculate on movements in the VIX in a number of other ways: VIX futures, VIX options, VIX ETFs ($VIXY).

That was VIX 101! I hope it was helpful.