Learn about the VIX and other volatility indexes and how some investors use them to assess potential risk.
Editor's note: Volanthology is a multi-part series on volatility, the various means of tracking volatility and incorporating volatility assessments into trading and investment research. Part 1 introduces historical and implied volatility, the VIX and other equity volatility indexes.
When you hear the phrase "stock market volatility, what's the first thing that pops into your mind? If you're like many investors, you think of the VIX—the CBOE Volatility Index, aka "the fear index." And sure, that makes sense. VIX, which is made up of the implied volatilities of a basket of short-term options on the S&P 500 Index (SPX), is widely viewed as the market's volatility benchmark.
But VIX is only one data point in one asset class, and in the world of volatility, there's a whole host of published volatility indexes, covering different asset classes, time horizons and geographies. Let's take a look at some of these indexes and how you might use them to help gauge uncertainty in a number of market segments.
Volatility (or "vol" for short), in its most basic definition, is the amount of market price variability over a period of time. So, in a sense, volatility can give you an idea of how risky an asset might be. The higher the vol, the greater the apparent risk.
Vol comes in two basic flavors, historical and implied. Historical volatility, also called "realized volatility" is a backward-looking assessment of how volatile an asset has been over a specific period. Implied volatility, however, is a forward-looking assessment based on actual market prices of listed options.
The VIX is an example of implied vol, specifically the implied vol of a basket of options on the S&P 500 Index (SPX), normalized to a 30-day constant maturity. Think of it as a consensus estimate of future volatility, given the prices of options expiring in the next month or so.
Some traders say the stock market takes the escalator up but the elevator down. This phenomenon (or at least the fear of it), means the stock market tends to move in the opposite direction of implied volatility, and is probably why VIX is known as the "fear index." As markets tick down, and as VIX spikes, it often becomes front page business news.
But volatility indexes are more than just attention-grabbing headlines; some traders use them to help with their portfolio selection, asset allocation and diversification, and for some, even market timing.
Traditionally, when you wanted to know how risky a stock investment might be, one thing you might consider is its beta—a measure of an asset's variability relative to the market as a whole, or versus an industry benchmark such as the S&P 500 in the case of equity investments. But beta isn't a perfect measure. Just like historical vol, beta is backward-looking, meaning it only considers past movement versus the benchmark to determine expected variability versus the benchmark. Plus, since beta is a single number, and not part of an index or time series, it can't tell you how an asset might have performed in different market conditions such as bull and bear markets.
For example, figure 1 shows VIX versus its Nasdaq-100 counterpart, the CBOE Nasdaq-100 Volatility Index (VXN), which tilts more heavily toward technology and other growth stocks than the S&P 500. Though the two indexes appear to rise and fall at about the same time, VXN has been higher during times of relative calm, but the two appear to have converged during times of market stress. At a couple points, VXN was even trading below VIX.
FIGURE 1: CONVERGE, DIVERGE, INVERT.
Though these two equity vol indexes, the VIX and the VXN (blue line), tended to rise and fall at roughly the same time, there have been clear periods of divergence between the two. Data source: CBOE. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Of course, past performance is no guarantee of future results. Nor are forward-looking measures, either. Vol indexes and other measures of implied volatility are simply a snapshot of the current sentiment toward future price variability.
CBOE also publishes volatility indexes on the Dow Jones Industrial Average (VXD) and the Russell 2000 (RVX). The exchange group also publishes vol indexes on a few widely-held stocks and exchange-traded funds (ETFs). Other vol indexes cover sectors and asset classes such as energy, metals, interest rates and foreign exchange. There's even a VIX of VIX (VVIX).
These and other volatility indexes can help you assess the potential risks in certain market segments. They can tell you how volatile certain stocks or sectors have been relative to other investment alternatives. They can also give you a glimpse of how some assets performed during times of market stress.
In future installments of Volanthology, we'll look at a few of these other segments, and how they might be helpful in assessing potential investment ideas.
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