By: James Overmoyer
Have you heard of VIX? If you have, then you know that many investors are betting against, or shorting, it right now. VIX, in simple terms, is a measure of the stock market’s volatility and risk. The measure is used to show the fluctuation in prices throughout the entire market and the risk involved in investing in the market, by measuring how much these prices can change.
For example, imagine you’re buying a toothbrush and planning to sell it back later. VIX will tell you how much the price of your toothbrush might rise or fall.
VIX is measured by the amount that investors are willing to pay for an option - an agreement for the investor to buy or sell a stock at a specific price in a certain period of time. If investors are buying more, then the premiums go up; the opposite is true if there are more investors selling options. When the premiums go up, VIX will rise with it. VIX is also used to measure the annualized standard deviation for the S&P 500. What that means is, when VIX is at 20 percentage points, for example, then the S&P 500 will stay within +/- 20% over one year.
VIX is known as the “fear index.” VIX is often seen as an indicator of the future; when VIX is high the market typically drops down rapidly. Some people like to trade VIX, like other securities. Last year, the shorting of VIX gave investors a 190% return. However, shorting VIX is dangerous because VIX is unpredictable.
VIX is essential in understanding investor mentality. Every day, investors consider many metrics like historical and implied volatility. Historical volatility is statistical volatility determined by closing prices over a timeframe of 10-180 days. Historical volatility can determine if there are higher than normal levels of volatility. Implied volatility gauges the imbalances of supply and demand to determine future volatility. Implied volatility can be affected by a single company or market-wide events. For example, there could be news of an expected higher earnings two days before the earnings are reported. In turn, both option premiums (or the price of a stock) and implied volatility would rise. However, after the earnings are reported, the implied volatility is likely to decline in the absence of an event to drive demand and volatility.
So what does this mean for you? Knowing how the market is moving is essential to understanding the correct time to buy and how to make money off the market. Even if you’re not actively buying or selling stocks, recognizing the impact the stock market has on your money, regardless of where it is housed or how you are earning it, is important, and VIX plays a significant role in that impact. For more knowledge and expertise, ask me a question by emailing firstname.lastname@example.org.