Definition of Vix index

The Vix index is an index of expected future price volatility implied by options contract prices.  It is often called a fear index because its value rises when investors are concerned about future volatility.  However, high values of the index do not imply that the market will fall - they merely indicate that investors expect that prices will move up or down substantially in the future.[1]

The method of calculation for the Vix has varied through time. When the index was first conceived in the early 1990s, the methodology was quite simple: the volatility input was reserve engineered from a Black-Scholes pricing model given a known market option price (for at-the-money options only). In the mid-2000s, the Chicago Board Options Exchange (the Vix’s parent) decided to introduce a much more technically complex approach, whereby many more option prices are used and drawing on the latest Wall Street mathematical gimmicks. A few years ago, the CBOE began to list derivatives on the Vix, a market that has grown considerably. The Vix’s main importance may lie in the fact that many practitioners may influence their decisions and actions based on the level of the index, with the Vix essentially being given the power to move markets. This could be a problem for one main reason: the Vix may not truly mean what it is conventionally assumed to mean (expected volatility), and therefore we would be allowing an undecipherable ghost to move markets. [2]

Example
Vix indices are computed for various instruments.  The most important Vix index is the S&P 500 Vix index, which is computed using data from S&P 500 options contracts.  It is a weighted average of the prices of various S&P 500 index options contracts.  The contracts are chosen and weighted to ensure that the Vix index represents market expectations of volatility over the next 30 days.

Option contract prices depend on many factors, the most important of which are the strike price, the price of the underlying instrument, the time to maturity and the expected future price volatility of the underlying instrument.  When expected volatility is high, option prices are high. Carefully chosen averages of option prices thus can estimate volatility.

Vix index values are expressed in annual percentage points.  For example, a value of 20 indicates that options traders expect that returns to the S&P 500 index over the next 30 days will evolve as though they were produced by a process that would generate returns with annual returns with a 20 per cent standard deviation, on average.  In practice, the realised standard deviation will differ from the implied standard deviation. [3]

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