The VIX: the price of protection.

01August 5, 2024: from 23 to 65 before the bell

On Friday, August 2, 2024, the VIX closed at 23.39. On Monday, Japan's Nikkei index fell 12%, and before the US market opened, S&P 500 futures were down sharply.

Before the opening bell, the VIX touched 65.73, nearly three times Friday's close. People asked whether the index was broken. It wasn't; it was doing what it is built to do. The VIX is calculated from the quotes for S&P 500 options, not from trades, and that morning the gap between buyers' and sellers' quotes on put options had widened sharply, as the Bank for International Settlements found when it studied the day. The number was right by the rules. It was also the price of insurance at a moment when almost no one was selling any. That is what the VIX is: a price, not a thermometer.

By the close it was back to 38.57. Spike, then fade: that is what it usually does.

02What the VIX measures

Cboe calculates the VIX from the prices of a wide range of options on the S&P 500, puts and calls, at strike prices above and below the index. Those prices say how much the market expects the index to move over the next 30 days, and the VIX expresses that as a yearly percentage. In Cboe's own words, it is "a non-directional, annualized expectation for the standard deviation of the S&P 500."

It looks 30 days ahead, so it doesn't capture options that expire the same day, now a large share of S&P 500 options trading (the options positioning lesson has more); Cboe publishes a separate one-day index, VIX1D, for those. Daily values of the VIX go back to 1990. The options lesson explains why an option's price depends on expected volatility; the VIX runs that logic backward, reading the volatility out of the prices.

03From a VIX number to a move

The VIX is quoted as a yearly percentage, so to get the move for a shorter stretch you shrink it by the square root of time. A month is a twelfth of a year, so divide by the square root of 12, about 3.5. For a single trading day, divide by about 16, the square root of the roughly 252 trading days in a year; this lesson uses that convention. (Some of Cboe's own examples count calendar days instead and divide by about 19; the difference doesn't change the picture.)

These conversions assume a smooth bell curve. Real markets have more quiet days and more wild ones than a bell curve allows: the biggest moves, three standard deviations and beyond, come far more often than a bell curve allows, which is part of why the options cost what they do.

04Why it spikes, and why it fades

When stocks start to fall, investors rush to buy protection, put options on the S&P 500, and option sellers demand more for writing them. Option prices jump, and so does the VIX. Wild days also tend to come in clusters, so one big move raises the odds of another, which the options price in.

Then it fades. Panics end, or at least slow down, and the VIX drifts back toward its long-run average. Since 1990 the VIX has closed at 19.4 on average, and half of all closes were below 17.6; its highest close was 82.69, on March 16, 2020, and its lowest 9.14, in November 2017. It closed above 40 on only about 2% of days. That pull back toward the average is one of the most reliable patterns in markets, but it keeps no timetable. After August 2024 the VIX was back below 20 within eight days. After its 2008 peak, 80.86 on November 20, it didn't close below 30 until May 19, 2009, six months later. Betting on the fade too early is how volatility sellers get hurt.

05The fear gauge, half right

The nickname comes from a real pattern: the VIX usually rises when stocks fall and falls when they rise. Since 1990, on about four trading days in five, the VIX and the S&P 500 have moved in opposite directions. But the VIX measures the size of the expected move, not its direction. A market that is expected to swing sharply either way, after a crash or into a scheduled event like an election or a Fed meeting, can carry a high VIX even when nobody knows which way the move will go.

And a low VIX is not the same as low risk. It means protection is cheap, which can lead investors to buy less of it and take on more, right before something goes wrong.

06Expected against actual

The VIX is what options expect. Most of the time, what actually happens is calmer. OptionMetrics, an options data firm, found that from 1996 the VIX was higher than the S&P 500's actual volatility over the following 30 days about 84% of the time, by around 4 percentage points on average. That gap is the insurance premium: buyers of protection pay a little more than it usually turns out to be worth, the way insurance customers do. The other 16% of the time includes the worst stretches in that span, like 1998, 2008 and 2020, when the actual moves ran far past what was priced.

Which means selling volatility makes money most of the time, and that is the trap. On February 5, 2018, the VIX jumped from 17.31 to 37.32, up 116% in a day. XIV, an exchange-traded note that paid off when volatility fell, fell by more than 80% in value that day, by its issuer's own measure, and the issuer, Credit Suisse, shut it down.

07You can't buy the VIX

The VIX is a calculation, not something you can own. To trade it, people use VIX futures and options, and funds and notes that hold those futures. That brings back the problem from the contango lesson: VIX futures usually sit in contango, above the VIX itself, and drift down toward it as they expire. Products that hold them and roll lose that gap, month after month. And when the VIX spikes, they rise less than it does: the futures price where the VIX is expected to be in a month, not where it is today. The prospectus for one of them, VXX, tells buyers that "the long term expected value of your ETNs is zero."

08Try it: read a VIX number

Set the VIX, the index level and a time horizon. The gold curve is the range of outcomes the options are pricing, with the band one standard deviation either side; the dashed curve is the same thing at the VIX's long-run average, for comparison.

Slide the VIX from 12 to 40 and watch the curve flatten and spread: the same index, more than three times the expected move. Then set it to 80, about where it closed at its record, and look at a single day.

09Who feels a spike

10Common misreads

• "A VIX of 30 means stocks will fall 30%." It means options are pricing a typical move of about 8.7% over the next month, either way: 30% at a yearly rate.
• "The VIX predicts crashes." It reacts to them. By the time it spikes, the fall has usually started.
• "A low VIX means it's safe." It means protection is cheap. That is not the same thing.
• "I can buy the VIX if I think it will rise." You can buy futures, options or funds tied to it, and they rise less than the VIX when it spikes, and bleed while it's calm.