Financial markets can sometimes go through periods of turbulence, characterized by unpredictable and volatile price trends. One of the most used indexes by traders to measure volatility in stock markets is the Volatility Index, usually known as the VIX index. Let’s go over what it measures and how it can be used by investors.
What is the VIX Index and What Does It Measure
As anticipated, the VIX index is an indicator used to estimate volatility in stock markets. Created in 1993 by the Chicago Board Options Exchange (CBOE), it was one of the first international indicators to focus on the hypothetical determination of market volatility.
Among the many names that have been given to the VIX index, one of the most common is that of “fear index”. The fear referred to concerns market sentiment, i.e. the perception of the trend and opinions of investors. It can therefore be said that the VIX index indicates the opinion of the general public regarding the stability or development of the stock market.
Simplifying, financial markets can present two main trends: a bullish scenario and a bearish scenario. The work carried out by the experts consists in trying to formulate hypothetical and reliable forecasts on the future trend of a given asset, in order to orient the correct investment strategy.
How it is used
Like other indicators, the VIX index proves to be an effective thermometer for monitoring the temperature of the American market, which in turn exerts a considerable influence on international stock exchanges. Short-term investors (e.g. intraday traders) use this indicator consistently to make investment decisions.
When the VIX (or the VIX future) shows a sudden rise, it is important to understand and analyze the reasons. In order to better understand the interpretation of the VIX, we can use the example of car safety lights: a careful reading of the index movements usually provides clear signals useful to make an investment choice with the right timing.
There are also many traders who use the VIX index to hedge their bullish positions: in this way, they do not have to liquidate the bullish position, but can enter the VIX to offset any losses in the stock market. From a purely evaluative point of view, it is important to be able to catch all the signals that arise, paying attention to some numerical thresholds. For example, if the VIX rises above the threshold of 30 points, according to experts it represents the signal of an increase in volatility. On the other hand, if the index falls below 20 points, for analysts it is the symptom of a reduction in volatility.
VIX Index and S&P 500: What they have in common
The functioning of the VIX index is linked in part to one of the most important indices of the American stock exchange, the S&P 500. This is one of the most relevant indices, within which the 500 companies with the highest market capitalization of the entire American economy are incorporated. Today, thanks to a wider and more complete basket, it is considered the main index of the American stock exchange, ousting the Dow Jones from first place.
VIX and S&P 500 are two indices that, although presenting an evident mutual interconnection, denote some conceptual differences. If the S&P 500 includes a basket of equities, the VIX represents a non-retroactive valuation index. This essential characteristic prevents the index from formulating retroactive studies, as the estimates only refer to the 30 days following the use and analysis of the index.
Based on the S&P 500 index, the VIX index deals with quantifying the price variation (in percentage terms) in a specific time interval. Just the fact of being expressed in percentage values means that, graphically, it is possible to visualize a minimum value of zero and a maximum value of 100.
Furthermore, the VIX is useful because it offers a measure of the options on the S&P 500 index. Options are nothing more than contracts that give the subscriber the right (but not the obligation) to trade the S&P 500 Index at a price and term predetermined at the time of subscription.
VIX Index Quotation Today
One of the most interesting aspects of understanding the VIX index concerns its pricing. The VIX rose to prominence in the early stages of the pandemic, in March 2020. In that situation, the quotation of the VIX exceeded the threshold of 65 points, a value that had not been recorded since the financial crisis of 2008 (when the increase of the index was even more pronounced, touching 80 points in October 2008).
The change in the index itself, when compared to its historical average, provides evidence that this has been an extraordinarily volatile period, with very few similarities throughout history. The arrival of Covid-19 helped generate turbulence and concern in the financial markets, with all major global indices posting major losses in the course of a few weeks.
The gradual easing of restrictive measures also brought calm back to financial markets, contributing to the recovery of equity indices and, consequently, to the decline in the VIX. Suffice it to say that 2020 closed with a VIX below 25 points, a value that remained constant throughout 2022.
Final Considerations and Forecasts for the Future
In light of what we have analyzed, it is necessary to point out certain aspects. If it seems obvious that observing the VIX chart is a good way to monitor market sentiment, it is also true that it is necessary to understand the exogenous factors that can have an impact on index quotes (such as the geopolitical context). When studying a financial market, regardless of the specific country, there are elements that can guide the analysis of experts and financial analysts.
For all the reasons outlined above, before investing, it is advisable to identify the online trading platform that best suits your specific needs. There are a number of regulated brokers that allow you to trade a wide range of financial instruments. One of the most renowned is eToro, thanks to its intuitive platform and the presence of a demo account that allows you to start investing with virtual money.