High market volatility has been a defining feature of 2020. But even during less eventful years, market volatility is inevitable—especially in the short-run.
In financial markets, volatility measures exactly how risky a particular asset is over a period of time, so when an asset’s price fluctuates quickly within a short timeframe, it is considered highly volatile.
Standard deviation is one way of calculating and measuring volatility statistically. Over the past two decades, a wide range of volatility indices on different asset classes, as well as volatility exchange-traded products, have been developed.
Today, we'll take a deeper look at one such index and an exchange-traded note (ETN) idea ideal for short-term investing:
THE VIX INDEX
The CBOE Volatility Index (CBOE:VIX) became the first implied volatility index when it was introduced by the Chicago Board Options Exchange (CBOE) in 1993. Its calculation was later revised in 2003. Also known as the "fear-index" or "fear-gauge," market participants regard the VIX index as the premier benchmark for US stock market volatility.
VIX is based on the S&P 500 Index (SPX), which is regarded as the core index for US equities. The detailed calculation of the VIX index is beyond the scope of this article. But at its core, the VIX number shows the market's expectation of 30-day forward-looking volatility, implied by the prices of S&P options. Implied volatility is what the market is “implying” the volatility of an asset will be in the future, based on changes in option prices.
Implied volatility is derived from the cost of the option on an asset (such as an index or a stock). It is a dynamic number, reflecting market developments. For example, when a company is about to release earnings or makes a major announcement on a product, such as a potential vaccine, traders may revise trading patterns on specific options.
As a result, prices of those options may fluctuate up or down, independent of the actual stock price movement, so if there were no options traded on a given index or stock, there would be no way to calculate implied volatility. It is important to remember that implied volatility is based on consensus in the marketplace, but not necessarily a definite predictor of movement in asset prices.
VIX is regarded as a useful tool for investors to appreciate the sentiment in broader US equity markets. Overall, the index tends to spike when the S&P 500 drops sharply, and it usually declines steadily during bull markets.
VIX Weekly Chart
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