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Tuesday, 13 October 2020

Enterprise Explains: The VIX

Enterprise Explains: The VIX. Cast your mind back to March of this year. Global markets were spiraling the drain as investors freaked out over the coronavirus. Equities suffered one of the most rapid descents in history, yields on US treasuries collapsed to record lows, and the short-term funding markets seized up. Amid the chaos, the VIX — one of the leading indicators of risk in the US equity markets — surged to a record high, eclipsing the previous peak seen during the post-Lehman phase of the 2007/08 financial crisis.

What is it? The so-called “fear index” measures expectations of volatility of shares on the S&P 500 over a forward-looking 30-day period. The higher the number, the more volatile the market, while a low number indicates a low-risk environment. It’s worth emphasizing this important caveat: the index does not mention actual volatility and doesn’t claim to know what will happen in the future. It is based purely on the expectations of market participants and isn’t necessarily a watertight indicator of risk.

Reading the index: For the better part of the decade, the index traded at low levels ranging between 10 and 20 — but what does this actually mean in practice? Although the VIX measures volatility over a 30-day period, the figure you see on the chart is annualized. A reading of 25 tells you that prices can be expected to move up or down by 25% over the next 12 months, but what we’re really interested in is what happens in the short term, 30-day period. To do this we divide the number by 12. Take the example of what happened in March, when the index closed at a record high of 82.69. By doing the calculation we see the index is telling us to expect share prices to fall around 6.9% over the coming 30 days.

Going a bit deeper: The index arrives at these figures by looking at the market prices of stock options. Essentially, these are contracts traded by investors that allow them to buy and sell shares at a certain time in the future at a certain price. Options prices are higher for volatile shares (think of this like insurance) and lower for companies trading at a more stable price. Using these premiums as a benchmark for risk, the VIX calculates a weighted average through the day as contracts are bought and sold by traders. As options prices rise, so does the index (and vice versa).

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