How is the Vix index calculated and traded on?

The first week of February saw $4 trillion wiped off the value of shares around the world with the Vix index - or 'fear index' - reaching record levels. Philippe Mueller, Professor of Finance, explains how the Vix is calculated and how it has become an asset class of its own.

The Vix - or the CBOE (Chicago Board Options Exchange) Volatility Index to give its full name - is calculated using options traded on the S&P 500. More precisely, the Vix is a model-free measure of volatility implied by options traded on the S&P 500 index.

Up until last week the Vix had been hovering around all-time lows with some speculation that it indicated the stock markets were becoming complacent. 

However, the Vix was not ignoring the economic and political 'noise', rather the traders were apparently pricing the options in a way that assigned a relatively small weight to the noise.

How has betting on the Vix changed in recent years?

Over the last decade it has evolved into an asset class of its own and has become easier to trade instruments that are related to the Vix. Looking at some summary stats it becomes obvious that the Vix only really spikes during crisis periods.

An instrument that pays out when the Vix spikes is, hence, a good hedge against stock market turmoil. On the other side, there is an opportunity to earn profits by investing in instruments that pay out when the Vix is low and lose value when the Vix spikes.

This is the equivalent to selling insurance on the stock market: you pocket a small premium during normal times and are faced with large losses/payouts during crisis periods.

More recently, it has become easier to trade such instruments. Having exposure to volatility is risky and investors need to be compensated for having exposure to these risks.

In February the Vix reached its highest level in two and a half years. Hence, it is most likely the first time that investors in these instruments that were actively seeking exposure to volatility risk have faced large losses.

The difference between the Vix and a forecast of stock market volatility is known as the volatility risk premium, where options have historically traded above the subsequent realised volatility of the stock market.

So options prices tend to trade with an embedded risk premium and it gives an idea to what extent exposure to volatility is compensated.

The issue may be that investors that took on exposure to volatility risk did not fully understand the characteristics of their investment. Namely that they are collecting a small premium in good times, but can face huge losses in bad times. This is another example of “picking up nickels in front of a steamroller”.

Is the Vix a useful guide to stock market volatility or a follower?

The options used to calculate the Vix are priced in real time, but they are forward looking as they mature only at some point in the future.

Technically speaking, the Vix is the risk-neutral expectation of future volatility. Hence, the Vix is a leading indicator but not a perfect predictor. 

Philippe Mueller teaches Fixed Income and Credit Risk on the MSc Finance and Financial Risk Management on the MSc Central Banking and Financial Regulation.