What is the VIX and how is it calculated?
VIX - Volatility Index
When refering to the “VIX”, we generally mean the index which gives us a figure (as a percentage) of annualised, implied 30 day volatility for the S&P 500 Index. Just like the S&P 500 Index, the VIX cannot be directly traded. Therefore, the index itself is not calculated using day-to-day supply & demand of an underlying (well, it is, but we’ll get there).
With VIX reading “16” and assuming 252 trading days each year, to get a figure of expected daily moves, we take the index value and divide it by the Square Root of the number of trading days in a year. This will give us a value of the expected daily moves of the S&P 500 Index:
Expected Daily Moves = 16 / Sqrt(252) = 1%
Thus, a VIX reading of 16 means we should expect 1% daily moves.
(Actually, it’s 1.0079052…%. But for quick calculations, you can assume the Square Root of 252 is 16).
This is what the market is implying we should expect over the next 30 days.
To get an estimate of the 30-day Implied Volatility, linear regression is used to map between two separate option expiries:
Near-term - >=23 Days to Expiry
Next-Term - <=37 Day to Expiry
The expiries included in the calculation are rolled once a week.
To get the volatilities of the individual near-time and next-term expiries, the out-of-the-money (above the market Calls and below the market Puts) options are weighted based on their mid-price (the price between the current Bid & Ask) and are inversely proportional to the square of the option’s strike price.
The key thing to take away here is that only out-of-the-money options are included. What this means is that as the market moves, the options that are included in the calculation are constantly changing.
A typical view of the market is that upside is good, downside is bad. As downside is perceived as bad, more Puts (below the market) are generally bought and market participants are more willing to pay more for the protection they provide (and therefore to makeup for this disparaty, higher IV’s), hence, a dropping market is typically associated with an increasing VIX and visa versa. This is not always the case but it has lead to the VIX being labelled the “fear index”. A higher reading has broadened the range of expected future returns (see our article on Implied Volatility).
Footnotes:
VIX is a trademark of the CBOE. (https://www.cboe.com/tradable_products/vix/)