According to Wikipedia:
"The VIX is calculated and disseminated in real-time by the Chicago Board Options Exchange. It is a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations. The goal is to estimate the implied volatility of the S&P 500 index over the next 30 days."So what does this gobbledigook actually mean? Let's talk about options for a second. An option is a contract between two entities to buy or sell a certain security, for a certain price, a certain amount of time in the future. Now, let's say that the value of the S&P Index today were 1,000 (we wish), and the two of us make a contract that will allow me to buy the index from you 30 days from today at a value of 1,200 points. Clearly, this contract is not good for me today, since I could buy the index on the open market for 1,000, but maybe I am thinking that the value of the index could be at 1,300 next month and at that point buying it from you at 1,200 would be a discount that would allow me to make money. Now, you are thinking the same thing. You know that there is a chance you will lose money on this deal we are making if the value of the S&P will rise too much, so you demand a price for selling me this "option" that compensates you for the risk you are taking, and naturally, you will demand a higher price if you are thinking that you are taking a larger risk.
The genius of the VIX is that they take all these options contracts and figure out what risk or what volatility we are each expecting to see in the market over the next 30 days. They can do this, because this perceived risk is implied in the price we set for the option. I gotta tell you, I am amazed at the sort of thing people can figure out.
So what what can we tell by using the VIX? Once again, from Wikipedia:
"The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis. For example, if the VIX is at 15, this represents an expected annual change of 15%; thus one can infer that the index option markets expect the S&P 500 to move up or down over the next 30-day period."
Or to use the numbers from this morning: the VIX stands at about 65 so the implied volatility of the S&P over the next 30 days is 18.7% up or down... yowza! I don't know if we are going to have a good month or a bad month, but one thing for sure is that we are not going to have a boring month...
Can anyone add more insight on this subject? I would love to learn more.